Capital allocation underlines how and where an organisation invests and distributes its financial resources, increasing profits and boosting efficiency. A company's management team plans and decides how to allocate capital so that its shareholders can maximise their wealth.
Generally, the chief financial and chief executive officers make this decision for the companies. They can achieve this by implementing effective strategies. These tactics are beneficial for maximising profits, increasing employee efficiency, and building shareholder wealth.
So, let’s discover the importance of business growth strategies with proper capital allocation.
Why is capital allocation necessary for business growth?
Capital allocation is a strategic financial decision that determines a company's success over the years. Thus, business leaders should know how to distribute capital. They must consider several possible investment options and evaluate their potential. Again, they can allot additional funds with proper strategies to generate the best outcomes.
However, if the desired allocation strategy fails, the company and its shareholders will miss several valuable opportunities. Thus, the company must allocate its capital with immense responsibility and tactically.
Moving on, effective capital allocation results in long-term returns on investments, accelerates company growth, predicts the proper paths of development, and delivers returns to shareholders.
Practical strategies for capital allocation
The more cash a company has, the more options it will get for allocating capital. So, in this section, you will learn some valuable capital allocation strategies for businesses.
Organic growth investment
Organic growth investment is one of the common investment strategies for businesses. It helps enhance profit margins, operating efficiencies, and revenue growth rates. However, the company must have sufficient capital and business unit profitability to get a positive result from this capital allocation strategy. Businesses can experience organic growth by optimising existing products and services, expanding their presence in new markets, implementing new products, empowering supply chains, and streamlining sales and marketing strategies.
Mergers and acquisitions (M&A)
M&A is one of the risky investment strategies for businesses as it involves external resources. Mergers and acquisitions mean when a business is merged with or acquired by other companies. Though it includes serious risks like overpayment, M&A paves the way for improving performance, scaling up, and long-term profitable growth. The effective M&A strategies deliver the benefits like:
- Entry into the new markets
- Gaining superior resources and talent
- Achieving economic scope and scale
- Diversify the investment portfolio risk
- Constructing a competitive edge over others in the market.
Paying out business debts
Repaying their debts on time is an effective capital management strategy. So, the leaders must identify and analyse their debts from the company's balance sheet. Specifically, the companies should pay their debts when the interest rates are significantly low. The low interest rate provides a better opportunity for businesses to repay their debts because it will result in less expenditure. Otherwise, they will need to pay unnecessary and extra money, affecting profitability.
Thus, they need to find impactful solutions for the debt payment. For instance, they can arrange excess cash to improve the debt-to-equity ratio.
Paying off dividends
Through dividends, the businesses distribute profits among their shareholders. The board of directors decide the payment amount for this capital allocation strategy. This amount also depends upon proportional changes, such as increments or decrements in the stock price. This strategy promotes reinvestment in the company and helps to return free cash flow to the shareholders. Thus, the investors also value this strategy, and they can achieve capital gains from the dividends.
Share repurchasing
Some businesses prefer to purchase back their shares from the market. They can buy the shares from the open market or through a tender offer. It helps the companies to decrease their outstanding shares, improve financial ratios, and reduce reinvestment. As a result, the company's existing shares become more precious to the shareholders. The other advantages of share repurchasing are:
- Tax savings
- Increment of cost of the undervalued shares
- Detect an ideal capital structure
- Create a compact company control
Conclusion
Effective capital allocation plans strengthen a company's income, investment, and revenue and create new business growth opportunities. Tech giants like Google, Apple, and Facebook are excellent examples of companies that have achieved success through effective capital allocation. However, you should also be aware of poor capital allocation strategies, as they lead to low stock prices and stagnant growth.
So, if you want to master the art of capital allocation, you must check out the professional courses at Imarticus Learning. Their CFA course will guide you to make financial decisions like a pro and gain maximum profits.
