5 Capital Allocation Strategies
While corporate strategies are often dynamic and shift rapidly with the market winds, far too many companies fail to adapt their resource allocation accordingly. Instead, they remain set in their ways, allocating the same resources to the same business units time and again.
This refusal to adapt undermines a company’s strategic direction and inhibits its ability to implement the bold initiatives necessary for growth. In a study on the matter, McKinsey discovered that approximately one-third of capital allocation business units were essentially fixed. They dubbed this phenomenon: “Resource allocation inertia.”
Are you stuck in this pitfall? Do not worry; there is a way out.
Today, we will discuss five capital allocation strategies you should consider to ensure that your company dollars are being directed to the channels and activities that align with your corporate strategy.
What Is Capital Allocation?
Developing a capital allocation strategy is the process of distributing, re-distributing, and investing a company’s limited financial resources to maximize profits.
Typically, this process is carried out by the company’s CEO and CFO. Together, they and their executive teams consider their available avenues of investment and then project the impact those funds will have on the organization.
Having performed that projection and analysis, they then leverage the data to decide how to best spend the company’s hard-earned money, hoping those funds will have the desired effect.
Why Does Capital Allocation Matter?
There is an art to capital allocation. It is a process that translates financial strategy into action.
Carried out properly, it can empower business leaders to maximize profits, diversify revenue streams, and, ultimately, increase the company’s market value. But, as mentioned, failure to direct these funds to the proper channel could result in missed opportunities for the company and its shareholders.
As you might imagine, this is an enormous responsibility.
A company’s success hinges upon capital-allocation decisions made by financial leadership regarding available value-creation opportunities. Naturally, it will have a significant effect on long-term investment returns. Additionally, it will dictate how quickly the company grows, the direction the company grows in, and the amount of money returned to the shareholders.
Of course, the more cash a company has on hand, the more viable allocation options it will have to choose from.
Capital Allocation Methods
Let us say you are sitting on a large profit windfall. Flush with cash, you typically would have five primary allocation methods at your disposal:
#1 Organic Growth Investment
The most common allocation strategy businesses deploy is to invest the money back into the company’s business processes to drive improvements in revenue growth rates, profit margins, and operating efficiency. But the success of this investment strategy is largely contingent on the company’s capital capacity and business unit profitability.
It should be noted that this is a long-term strategy that will be unlikely to make its impact felt immediately. Typically, companies achieve organic growth by investing in initiatives that will:
- Enable the company to expand into new markets
- Optimize existing products and services
- Augment R&D
- Build out the supply chain
- Introduce new products and services
- Enhance sales and marketing strategies
For instance, an online retailer may decide to open up a brick-and-mortar location. Or a car company may invest more money into R&D to produce more sustainable, eco-friendly vehicles.
#2 Paying Off Business Debts
Repaying or repurchasing debt tends to be the most obvious choice for companies that have extra capital to allocate. That is because companies can already calculate the return on repaid debt ahead of time, particularly if the debt is a publicly-traded fixed income security.
That said, whether or not this use of capital will provide significant benefits will depend largely on the current interest rates. When they are low, companies are better off refinancing the debt and investing elsewhere, and possibly even issuing new debt so they have even more capital to invest. But, when interest rates are high, there is a significant incentive to pay it off prior to maturation.
#3 Mergers and Acquisitions
Although M&A is an inherently risky strategy, it also has the most potential to create strategic and financial value for a growing company by expanding its capabilities and opening up new revenue streams, which improve bottom-line profitability.
That is because instead of directing the funds internally, which tends to have a ROI cap, companies can acquire or merge with other businesses to build scale, improve performance, and, ultimately, drive long-term, profitable growth.
Potential benefits of strategic M&A activities include:
- Creating economies of scale and scope
- Gaining access to better talent and resources
- Diversifying the company’s investment portfolio risk
- Accessing new markets
- Building a competitive edge over other players in the market
But, as mentioned, M&A activity is likely the most perilous capital allocation strategy. As Harvard Business School notes, serious risks include overpaying, failing to perform proper due diligence, or miscalculating the potential synergies between the two entities.
#4 Paying Out Dividends
For publicly traded companies, another capital allocation strategy is to pay share dividends, whose profits are then passed on to shareholders. Naturally, this amount will be decided by the board of directors and will cause a proportional change in the stock price. This type of investment is advantageous since it:
- Demonstrates the company’s financial stability
- Returns free cash flow to stockholders
- Incentivizes re-investment
#5 Repurchasing Shares
The final capital allocation strategy is to buy back company shares. By reducing the number of outstanding shares on the market, a company can increase the share price, thus returning value to shareholders in a tax-efficient way. Advantages of this strategy include:
- Returning surplus cash to shareholders
- Increasing the price of undervalued shares
- Finding the optimal capital structure
- Enjoying tax savings
- Preventing a hostile takeover
- Centralizing company control
Making the Most of Your Capital with CFO Hub
For companies at this financial crossroads, determining how to properly allocate capital is rarely a quick or easy decision. Evaluating whether you invest in organic growth, pay off debts, focus on M&A, pay dividends, or repurchase shares depends on dozens of factors unique to your business and its place in the market.
Do you need help developing a capital allocation strategy?
At CFO Hub we can connect you with a perfect-fit CFO capable of providing the strategic advisory and financial modeling you need to make the best decision possible. An experienced fractional CFO could review your financial statements, consider your company goals and then determine the optimal capital allocation strategy for your business.
If you’re interested, schedule a free consultation today to learn more about our services.