Corporate Finance vs Accounting: One Year, Two Questions

Accounting asks what happened. Corporate finance asks what it is worth and what to do next. Both look at one business and one year, and they still produce different figures. Sankalp Industrial Systems Limited, an invented case, reports Rs 1,38,00,00,000 of profit for Year 0. The same business is forecast to have Rs 98,00,00,000 of cash free in Year 1. Neither figure is wrong.

The difference is not a disagreement about facts. Nobody is claiming the other side added up incorrectly. The two disciplines are answering two different questions, and a question decides everything downstream of it: what gets counted, over what period, against what standard, and in what shape the answer arrives. A record of what happened has to be complete, consistent and comparable, so it follows rules. A decision about what to commit next has to be about cash, about timing, and about what that money could have earned somewhere else, so it follows arithmetic instead. Both routes draw on the same underlying events, so the figures they produce can sit together without any contradiction.

Sankalp Industrial Systems Limited manufactures industrial valves and castings. Year 0 is its last completed year, and Year 1 is the year after it.

What is accounting actually asking, and what is corporate finance actually asking?

Everything that follows is downstream of the two questions, so the questions themselves come first. Most of the confusion between the two disciplines comes from people comparing an answer on one side with an answer on the other, without ever noticing that the questions differed. Defining each question properly, before setting the two against each other, is what prevents that.

The record: what happened?

Accounting exists to produce a faithful record of a period that is over. A shopkeeper who writes down every sale and every purchase at the end of the day is doing this on a smaller scale: deciding nothing, simply pinning down what took place so today can be set beside yesterday and beside the shop across the road. Scaled up, with rules so that every business writes it down the same way and an outside check so that the writing can be relied on by people who were not there, the result is a set of financial statements.

Because the subject is a period that has finished, the record can be exact, and an outsider can walk in afterwards and test it. A finished period is the whole reason the record can be auditedAn independent examination of a set of accounts by somebody outside the business, who reports whether the record fairly presents what took place.: an outsider who witnessed none of it can still test the record against the evidence for it. There is a fact of the matter about how many valves were shipped in Year 0 and what the customers paid. The rules decide when a shipment counts as revenue and how a machine bought once is spread across the years it works, and reasonable rule-writers argue about those choices, but once the rules are fixed the answer is determined.

The decision: what is it worth, and what should be committed next?

Corporate finance exists to decide what to do with the money. Should the third valve line be built? Should the growth be funded by borrowing or by the owners? Should the cash go back to the shareholders or stay inside? A household faces the same shape of question when it decides whether to put its savings into a shop: what matters is not what was earned last year but what the money will produce if it is committed, and what it would have produced if it had been left where it was.

Because the subject is a period that has not happened, the answer cannot be a fact, and it comes instead as a number attached to a set of named assumptions. The method is not weaker for it. An honest statement about the future has no other shape available to it. Anything else is a forecast wearing the costume of a record.

Why does one company in one year produce more than one correct figure?

Here is the fact that makes the distinction necessary. With Sankalp Industrial Systems Limited held still, one business, one set of books, one completed year and one forecast year, three separate figures come out, and all three are correct.

Read them as three attempts at one measurement and they look like a mess. Read them as answers to three different questions and there is no tension at all. The Rs 1,38,00,00,000 is a fact about a finished year, the Rs 36,00,00,000 is a judgement about that same finished year measured against what its capital cost, and the Rs 98,00,00,000 is a forecast about a year that has not started. Change the question and the figure that answers it changes with it.

The everyday version is familiar. A vegetable seller can state exactly what he took at the stall yesterday. He can also state that after the rent of the cart and the cost of the stock, yesterday barely covered what he could have earned working for somebody else. And he can state what he expects to be left over next month if he rents a second cart. Three true statements, three different questions, and only the first of them is a record.

Axis one. Which way is each one facing?

The first of four differences, and the one the other three follow from. A record faces backwards. A decision faces forwards. The remaining three axes all follow from that one.

A set of accounts covers a period that has closed. The events a set of accounts describes are over, so nothing in it can change. There is something to check against, and that is what lets an outsider be sent in. When Sankalp Industrial Systems Limited says it shipped what it shipped and was paid what it was paid, somebody can go and look at the shipping documents and the bank statements.

A corporate finance answer covers periods that have not run yet. There is no shipping document for Year 3. A forecast cannot be audited, and the correct response to one is therefore not to verify it but to interrogate the assumptions it rests on. When the forecast says Year 1 free cash flow will be Rs 98,00,00,000, the useful questions are what growth that assumes, what the company will have to spend to get it, and what would need to change for the figure to come out well below that.

Axis two. What is each one actually counting?

The second difference is what gets counted. Accounting counts recognised profit. Corporate finance counts cash that is actually free to leave the business.

Recognised profit and free cash are not the same quantity, and they are not meant to be. A machine bought in Year 0 is paid for in Year 0, but the accounts spread its cost across the years it will work, through depreciationA charge that carries the cost of a machine or a building into each of the years it will actually be used, instead of loading all of it onto the year it was bought.. Stock that has been built but not yet sold is money that has left the bank while the profit line has not moved at all. The gap between recognised profit and free cash is not an error in either direction; it is the difference between the year an event is recorded in and the year the money moves.

Think of a household that buys a scooter for a delivery business. The cash goes out in one month. The usefulness arrives over four years. A record spreads the cost across those four years to keep them comparable with each other. A decision looks at the money as it actually moved. The money as it actually moved is what constrains what can be done next.

So corporate finance takes the reported lines and rearranges them into cash. The rearrangement starts from operating profit, taxes it, adds back the charges that were spread rather than paid this year, and takes off what the business actually spent on capital expenditureOutlay on plant, machinery, buildings and anything else the business will still be using several years from now, kept apart from what it spends running itself day to day. and on the increase in its working capitalThe money tied up in the day to day cycle of a business: what customers owe it and the stock it holds, less what it owes its suppliers.. None of the reported figures is contradicted. The reported figures are simply put in a different order for a different purpose.

Axis three. What does a set of accounts never charge for?

The third axis is the one that surprises people, and it is worth slowing down on.

Sankalp Industrial Systems Limited paid its lenders Rs 48,00,00,000 of interest in Year 0. The interest was a contracted payment that actually left the company, so it sits on the face of the profit and loss account. There was a transaction, so there is a record of it.

Its shareholders had Rs 18,00,00,00,000 of equity in the business at market. The shareholders were charged nothing at all. Not because anybody decided equity is free, but because nothing left the company to pay for it. A set of accounts records transactions, and the cost of equity is not a transaction: it is what the owners gave up by leaving their money in this business instead of somewhere else.

The asymmetry between the two charges is most of what separates the two disciplines. Corporate finance closes it by making the charge the accounts never make. Take the capital the business has tied up, multiply it by what that capital costs, and deduct the result. For this company the capital tied up in Year 0 is Rs 12,00,00,00,000 and the cost of capital used throughout this worked case is 12.00 per cent, so the charge is Rs 1,44,00,00,000. How that 12.00 per cent is built is a separate subject and is covered on its own; here it is simply used.

Axis four. Does the answer come as one number or as a spread?

The fourth difference is the shape of the answer, and it is the one that most often gets borrowed across the boundary in the wrong direction.

A set of accounts gives one figure for the year. Profit belonging to the owners was Rs 1,38,00,00,000. Not about that, not a range around that. The events are over, so the figure is determined once the rules are applied, and giving it as a range would be a way of saying the record is incomplete.

A forward answer depends on assumptions that are choices rather than observations, so it cannot honestly be a single figure. Take the Year 1 free cash flow of Rs 98,00,00,000. The Rs 98,00,00,000 rests on a specific assumption: that the business puts Rs 1,00,00,00,000 of net new capital back into itself during the year. Operating profit after tax for Year 1 is forecast at Rs 1,98,00,00,000, so the cash left free is that figure less whatever the business reinvests. Move the reinvestment assumption and the answer moves with it:

The middle row is the forecast this worked case actually carries. The outer two rows are the same forecast with one named assumption moved, which is what gives a forward answer its shape. One assumption, moved by a fifth in each direction, moves the answer by Rs 40,00,00,000, and that is why a forward figure is presented as a spread with the assumption that produced each end written beside it.

The middle row is no likelier than the rows on either side of it, because each of the three carries one assumption through to its answer. A single number requires a single assumption, and burying the assumption does not remove it from the answer.

What do the four axes look like when they are put together?

Left unnamed, the difference between the two disciplines is remembered as a vague matter of emphasis, and people then argue about which discipline is right. Naming the four axes prevents that. The two sit at opposite ends of all four axes at once, and any one of the four on its own would already produce different figures.

What do the two routes look like on one year of one company?

Now run both routes on the same year and watch where they separate. Both start from exactly the same operating profit of Rs 2,40,00,00,000 for Year 0, and both take the same view of what the business did. The two routes part company at one identifiable step each.

Route one: what the accounts say about Year 0

Interest comes off first, leaving profit before tax of Rs 1,92,00,00,000, and the tax charge is struck on that. On 20,00,00,000 shares the last line works out at earnings per shareWhat the owners of the parent earned in the year, set against each share in issue, so one year can be laid beside another year or beside a different business. of Rs 6.90. The 25.0 per cent is this company's own assumed effective tax rateThe tax charge a business actually bears expressed as a share of its profit before tax, which differs from any headline rate because of how various items are treated. chosen for the worked case rather than set by any tax rule. The Rs 6,00,00,000 comes out because the group consolidatedAdding a subsidiary line by line into the parent accounts as though the two were one business, even where the parent holds less than all of it. the whole of Sankalp Coatings Private Limited while holding three quarters of it, so the remaining quarter belongs to somebody outside the group and is removed as a minority interestThe part of a subsidiary that belongs to shareholders outside the group, whose share of profit is removed before the parent owners figure is struck.. The Rs 1,38,00,00,000 is a complete and correct answer to the question what happened, and it is the end of the accounting route.

Route two: what corporate finance does with the same events

The step where the two routes separate is visible in the first two lines. The accounting route deducts interest and then taxes what is left. The corporate finance route asks what the business earned from operating, independently of how the business happens to be funded, so it does not deduct interest before taxing at all. The tax figure therefore differs between the two tables: Rs 48,00,00,000 in the first and Rs 60,00,00,000 in the second, on the same 25.0 per cent rate applied to two different bases.

And then it looks forward

For Year 1 the same arithmetic runs on a forecast rather than a record. Operating profit after tax is forecast at Rs 1,98,00,00,000. The business has to put Rs 1,00,00,00,000 of net new capital back in to support the growth it is forecasting, so what is left free is Rs 98,00,00,000. The Rs 98,00,00,000 is the third of the three figures, and the only one that covers a year nobody has lived through.

The one line that proves it is the same company seen twice

If the two routes really are two views of one business rather than two different businesses, the arithmetic should close between them. The arithmetic does close, exactly, and running it settles the point better than any amount of argument.

The bridge closes to the rupee with nothing left over. The value view and the reported view are one company looked at twice, not two companies. The interest of Rs 48,00,00,000 becomes Rs 36,00,00,000 once the tax relief on it is taken into account, because the corporate finance route already taxed the full operating profit as if no interest existed. Nothing has been added and nothing has been thrown away; the same rupees have simply been arranged in a different order.

Three figures in the worked case repeat themselves, and none of them is the other

Working on one company for long enough produces coincidences, and two of them are large enough to mislead a careful reader. The pairs are named below, before anybody subtracts one figure from its twin and finds a meaningless zero.

Each pair is an accident of this worked case. The two figures in a pair measure entirely different things. Subtracting one from its twin gives a clean, tidy and completely meaningless zero, and that is exactly the shape of an error that looks like a finding.

Where exactly does the handover happen?

People often imagine the boundary as blurry. It is not. There is a specific set of lines that crosses from one discipline to the other, and corporate finance changes none of them.

Four lines cross: the operating profit figure, the depreciation charge, the capital expenditure line, and the working capital balances. All four come out of the accounts exactly as reported and go into the cash arithmetic exactly as reported. Not one rupee of any of them is adjusted on the way across, and everything corporate finance does happens after the handover rather than to it.

Corporate finance does three things on its own side of the line: rearrange those reported lines into cash, apply a rate to compare money in different years, and produce a spread rather than a point. None of those three is an accounting operation and none of them touches the record.

Does any of this mean the accounts are wrong?

No. The opposite reading does real damage, so the answer is worth stating plainly.

The operating profit, the interest, the tax charge, the outside share, the capital tied up: all of them are reported figures, taken at their reported values. Corporate finance treats the financial statements as the complete record of what happened and as the source of every input it uses, and it adds a question the record was never designed to answer.

The record was built to be complete, consistent and comparable. The record succeeds at that. Asking it to also settle whether committing Rs 12,00,00,00,000 of capital was worth doing is asking a hammer to measure a room. The hammer is not defective.

There is a second half to this, and it runs the other way. An analyst who concludes that the accounts are therefore useless has thrown away the only complete record of what the business actually did, and then has nothing left to forecast from. Every forward figure above is built on reported lines. Discard the record and the decision has no foundation under it at all.

Which figure does a company report, and which one does it decide on?

The practical question underneath all four axes has a decidable answer rather than a preference.

For an account of what happened in a completed year, the reported profit figure is the right one and the cash figure is not an improvement on it. For a decision about whether to commit money to something, the cash figure and the charge for the capital are the right ones and the reported profit will mislead. Which figure is wanted is settled by the question being answered, so asking which of the two is better is itself the wrong question.

The same person often needs both within an hour. A board member reads the reported profit to know how the year went. The next item on the agenda is whether to build the third valve line, and there the reported profit is no longer the relevant number at all.