Capital allocation refers to the process of allotting and investing the financial resources of a company. The Chief Executive Officer (CEO) and the Chief Financial Officer (CFO) discuss and decide upon the capital allocation policies of a company to boost profitability and efficiency. Capital allocation is crucial for the efficient digital transformation of a company. The CFO plays a pivotal role in strategising capital allocation by focusing on client needs, supply chain management, capital budgeting, and such other factors to drive business growth.
Capital allocation is highly effective for the resolution of supply chain issues. A capital allocation strategy that is in complete alignment with the business goals of a company also helps in evaluating investment options. One of the key approaches to capital allocation is to hold extensive discussions between the CFO and the stakeholders of a company.
The CFO should furnish the stakeholders with pertinent information related to research and development investment, mergers and acquisitions, capital expenditure policies, and debts incurred by the company during the discussion. The stakeholders may engage in providing guidance and recommendations to the CFO for efficient capital allocation. Read on to gain a deeper insight into how the CFO manages capital allocation by the adoption of different strategies in order to drive growth and development in the company.
Strategic capital allocation management recommendations for CFOs
Capital allocation is key to the success of a company. It helps in assessing the future of the company. The pandemic, caused by the global outbreak of Coronavirus, has made capital allocation even more important for companies across the world. Economists, around the globe, recommend the following strategies for effective capital allocation:
1. Work on Mergers and Acquisitions (M&A)
M&A may sound risky for companies but research reveals that merging with or acquisitioning other companies is actually a prudent move. In fact, business organisations that partake in M&A ventures perform better even during financial crisis periods. Capital allocation to M&A also helps companies in acquiring substantial shareholder returns, especially at the end of a fiscal crisis period.
It is crucial to exercise due diligence before signing the M&A deals. The process of due diligence involves build-or-buy assessment and analysis of the new goods and services to be offered. Due diligence also necessitates a thorough understanding of whether the new goods and services can be purchased externally or created in-house. In a nutshell, capital allocation to M&A does not fail to contribute to business growth despite the risks.
2. Focus on capital allocation and reallocation whenever there is scope for growth
Take note of shifts in customer preferences, client needs, and such other factors to assess the areas of growth and stagnation. Quit hoarding cash and look out for novel investment opportunities instead. A top-notch way of identifying the areas of latent business growth is to follow the two-step process outlined by Harvard Business Review. In this process, the first step is to focus on the identification of particular goods and services that have the potential for growth.
The second step in this process is to assess whether the potency of growth is for the short term or the long term. This assessment helps in determining the products and services that will have the power to contribute to business growth even during financial crises. Also, take note of the market and industrial specifics for capital allocation or reallocation.
3. Try to avoid stock buybacks
Do not make stock buybacks a part of the capital allocation scheme. Instead, invest the money in the business for successful capital allocation. An important reason to avoid investing in stock buybacks is to save money for emergencies. Avoid buybacks and invest money in assets that will contribute to the long-term stability and growth of the company.
4. Make the capital allocation scheme evaluation a continuous process
In view of the rapidly changing markets, it is important to review and modify the strategies of capital allocation and capital budgeting continuously for flourishing business growth. Revisit and analyse the capital allocation scheme continuously to make sure that the scheme is consistent with the changes that prevail in the markets. It has been observed by economists that companies that re-evaluate their capital allocation policies consistently succeed in attaining higher net worth and revenues than companies that stick to the same policies year after year.
5. Take care of the dividends
If the company is going through a financial crisis then one of the ways in which the company can save money is by decreasing shareholder pay-outs. However, if there is no crisis, then there is no need to slash the dividends. Dividends are often used to provide financial support to the pensioners of the company. Capital allocation to dividends should be done in a way without disrupting the pecuniary future of the company.
Capital allocation involves extensive decision-making with regard to dividends, research and development, mergers, acquisitions, debt management, and other financial aspects of a company. It is the sole objective of capital allocation to elevate the shareholder value and stock returns of a company in the years to come.
Capital allocation is essential for the creation and maintenance of an investment portfolio. If you seek to devote your time to learning about capital allocation then you may enrol in the Chief Financial Officer course offered by Imarticus. In the Chief Financial Officer course, the candidate shall be able to gain a world of financial knowledge. From learning to assess the rapidly evolving market dynamics to taking control of capital budgeting during financial crises, the course covers it all.
Enrol in the course right away to develop a strong grasp on the concepts of capital allocation in companies.