CECL for Private Companies: What You Need to Know
The Capital Allocation Process: Methods & Best Practices Every CFO Should Know
So many questions, so few answers. Well, at least big, neon answers that light up the economically murky surroundings. Strike a chord? It’s what CFOs continue to trudge through, turning complex but familiar decisions like capital allocation into an unbridled strategic gambit. Or at least it feels that way.
But that’s the thing – depending on your industry, revenues might not be back to pre-pandemic levels yet. Or you could be looking possible recessionary forces straight in the face. Either way, it doesn’t mean your capital allocation decisions should make you feel like you’re sitting at a tactical roulette wheel. Instead, it might just be a matter of viewing them from a slightly different angle than usual.
Granted, that thought might not give you the warm and fuzzies right now but, as we’re about to show you, effectively allocating capital in the midst of uncertainty could just be a matter of getting back to the basics.
What is Capital Allocation? A Quick Primer
Capital allocation is exactly what it sounds like – where and how is your organization going to invest and distribute its money? Of course, it’s not just a matter of spending that money. Your capital expenditures are strategic decisions that should maximize efficiency, profitability, and long-term value, all while mitigating as much risk as possible.
Obviously, that’s not something a management team should take lightly as it entails quite a few moving parts, including:
- The financial viability of your different allocation options
- A thorough understanding of your strategic priorities
- The opportunity costs of the capital road not traveled
- Your ideal cost of capital, or at least some semblance of “ideal” between debt and equity
While that list isn’t exhaustive, it hits the main points behind capital allocation theory, a b-school classic if there ever was one. In essence, you combine your overall goal when allocating your capital – maximizing value – with critical concepts and processes like opportunity cost, sound and unbiased decision-making, and prudent risk management.
That, in a nutshell, is how any corporate finance textbook worth its weight will introduce the fundamentals behind the allocation of capital. The problem with such a rigid view, however, is that your business, market, industry, and customers don’t necessarily abide by textbook definitions.
As you know, the real world is much more dynamic than that, especially with many sectors still knee-deep in waves of uncertainty, whether from the pandemic, its repercussions, or other economic turbulence.
The Tools at Your Disposal: Capital Allocation Methods
Think of your capital allocation as a recipe. You combine different ingredients in different quantities to achieve your desired results. Yes, we understand that’s an overly simplistic view, especially with so many forces and variables threatening your capital upside-down cake at any given moment. However, despite the overarching complexities, you still have a distinct and finite set of financial resources and allocation tools to work with, no matter the circumstances:
You’re always walking a bit of a tightrope when it comes to debt. On one hand, all cash and no debt makes your enterprise a dull boy. Liquidity is obviously vital, as we saw at the height of the COVID-19 crisis when revenues were down and the future foggy at best.
Obviously, there’s a flip side to that coin, where too much debt and too little cash can quickly become an iceberg to your transatlantic voyage. As a corporate strategy, most companies find it helpful to identify an EBITDA multiple to peg their debt at, somewhere in the neighborhood of 3x EBITDA being a common mark. Anything above that mark would typically mean deploying capital toward debt servicing is probably a good idea.
Internal Growth Initiatives
Also called organic growth, these initiatives are usually relatively small, at least in comparison to your excess cash flow. But that’s not always the case. Sometimes internal growth initiatives are large, long-term reinvestments of cash, maybe a massive migration to cloud computing, a far-reaching digital transformation initiative, or updated equipment on a production line.
Either way, deploying capital towards internal initiatives means you’re investing in yourself, your people, and the tools you need for a successful future. While not as flashy as M&A-rooted capital expenditures, they’re just as vital, particularly for organizations trying to drive growth while also solidifying culture and engagement in this brave new world of remote working and teams scattered to the winds.
R&D is probably the most obvious example of such internal growth initiatives. While some industries don’t have much need for extensive R&D, others live and breathe by innovation. Therefore, it’s impossible to say that, for instance, 15% of your revenue should go toward R&D every year. Whatever metric is right for your operations depends on free cash flow, your competition, industry, and other factors.
Slightly confused at the sight of the term? Maybe a few beads of sweat forming on your forehead? You’re not alone. Far from it. Share buybacks tend to be somewhat of a mythical creature for many chief financial officers – like a financial Sasquatch – but mostly just from unfamiliarity. That said, they can also be a key weapon in your arsenal of capital allocation tools when used at the right time and under the right circumstances.
Just remember, your goal is to maximize shareholder value. Therefore, when swimming in the share repurchase pool, it’s important to be consistent and set the right tone and message for your shareholders. In other words, establish a price range for your buybacks and stick to it – cash permitting – even when your share price is down.
Of course, this assumes there are no better places for your capital at the time and the buybacks still provide an attractive internal rate of return (IRR) for your company. No matter what, just be sure to clearly communicate your thoughts with your shareholders since they’re the last ones you want to upset.
A cousin to share buybacks, dividends are a convenient way to return excess capital to your shareholders. However, don’t confuse popularity and familiarity with effectiveness. There are plenty of reasons why buybacks are often – but not always – a more attractive option for a CFO, tax efficiency being toward the top of the list.
But aside from the pleasant optics they provide for your company which, in reality, are a secondary consideration, dividends come in handy when you don’t have many obvious alternatives for your capital. They create value by providing a wider spread between your estimated cash flow and the investment opportunity costs of other capital deployment channels.
The rock star of the group, acquisitions have a habit of grabbing the spotlight and holding onto it, but not always for the right or best reasons. Sure, it makes for compelling copy when a CEO announces a “gamechanger” acquisition, but those massive transactions aren’t always what they’re cracked up to be.
When it comes to this brand of inorganic growth, it’s always in your best interest to gauge risk appropriately and maintain a realistic perspective on the challenges of a merger or acquisition transaction, big or small. Shiny object syndrome, while natural, can also be quite toxic when trying to effectively allocate your capital, potentially opening the door to inflated valuations, culture risks, and, ultimately, failed integrations. Our advice is to ensure that you, as the CFO, mitigate these risks and the myriad of others that might come your way by being the steadfast voice of reason, supporting your stance with analyses as you go.
As a final word on these different allocation tools available, just remember that one of your biggest challenges is finding the perfect balance between long-term growth and short-term value creation. That notion holds at all times, whether during a global pandemic, market-wide explosive growth, or anywhere between the two.
Put another way, it’s absolutely possible to have too much of a good thing, be it R&D, modest acquisitions that bolster your core competencies, an industry-jolting transaction, or even a dividend payout. And, not to add undue pressure or anything, but it’s up to the CFO to guide that critical decision-making and provide expertise to the CEO. In fact, that topic is so significant, it deserves its very own subheader.
The Role of the CFO in Capital Allocation
As a CFO, you’re far more than just the numbers person. You’re both the organization’s investment decision ringleader and soothsayer, reading the financial tea leaves to maximize value – both today and tomorrow – while also assembling and guiding the team to get you there.
These heady responsibilities begin with designing a framework that will allow you to compare capital apples to oranges. In other words, you need a system in place that will, for example, let you directly compare and contrast the benefits and downsides of a small acquisition versus an R&D investment strategy. Or a new piece of manufacturing equipment. Or an increased dividend payout. We could go on and on, but you get the idea.
Further, such a framework provides consistency and transparency across different investments that, at least at first glance, might seem too disparate for such comparisons. But that’s why a ragtag team of expert stakeholders is so vital to the capital allocation process.
Assembling Your A-Team(s)
Obviously, your decision-making depends on different areas of experience and expertise across your organization. And each of those areas plays a vital role in developing the models you use to compare the many ways to allocate your capital.
Through various metrics, scenarios, and projections, your ultimate goal is to assess every potential capital investment project through a uniform lens of the most pertinent value drivers and KPIs. And the CFO is responsible for assembling those teams that create the essential framework.
Once those teams are in place, your FP&A function works with the different business units and project managers involved to leverage your value framework. From there, you can develop the data needed to gauge the benefits and drawbacks of a potential investment or compare different investments side-by-side.
With time and continued practice, this entire process becomes second nature, ideally integrating finance transformation tools and concepts to further streamline your modeling and improve the accuracy of your metrics. And as a bonus, because this is such a collaborative effort, you can gather critical buy-in from these other stakeholders as you go, ensuring that your capital allocation strategy is truly an enterprise-wide endeavor. Not too shabby, huh?
Real-World Capital Allocation Best Practices
Before we let you go, we’ve also gathered a few best practices to share, all accumulated from the capital allocation frontlines and focused on three essential concepts.
1. Align Your Capital Budgeting With Your Strategic Initiatives
Where are you heading? What’s your bigger-picture plan? Before embarking – pun alert! – down the capital allocation road, you have to identify your strategic priorities. Maybe you’re just trying to generate good ol’ fashioned growth, increase efficiencies across your operations, or develop new products. Whatever your business strategy aims for, allocating your capital is a classic case of needing to put your money where your mouth is. Otherwise, your strategic priorities remain theoretical and never gain any real-world traction.
2. Don’t Skimp on Project Analysis
The more you know when kicking the tires on a potential project, the better. That starts with making sure your analysis framework is running on all cylinders. Likewise, all of the different business units and stakeholders involved must actively participate and bring the level of detail, insight, and skill you need to determine if the project is worth your while
Also, going back to the different metrics we referenced earlier, you want your analysis to go beyond the typical IRR and payback period calculations since they can be easily manipulated through financial models that, consciously or not, tend to be positively biased. This isn’t the time to sugarcoat anything. In fact, you want to err toward the conservative side of the spectrum.
Therefore, let your scenario testing fly, leaving no feasible theoretical stone unturned. To further that critical conservative mindset, you can even try to conduct “pre-mortem” sessions with your team, imagining that a project went south. This way, your group can walk through the different ways a project can go sideways, helping you uncover possible project potholes that might otherwise slip through the cracks.
3. Fortify Sound Project Investment Judgment
Lastly, you want to identify your company’s mechanisms for choosing projects and tracking them, making sure to properly heed any contrarian perspectives that cause you to pause and look at a project from a different angle.
Too often, cognitive biases wreak havoc on an organization’s ability to choose the right mix of capital projects for its goals. Groupthink, for instance, can be toxic for your capital allocation, where people tend to “follow the leader” rather than voice a dissenting opinion.
Similarly, anchoring decisions on skewed or incomplete data sets can support a choice that isn't ultimately in the business’s best interest. Instead, your return on invested capital (ROIC) should be the benchmark for your analysis and decision-making, helping you assess the risk involved and make fully informed, unbiased decisions.
We understand that at different times over the last few years, it’s probably seemed like risk is coming at you from every conceivable angle. However, the different best practices and insights we’ve discussed should serve as a guiding light for your use of capital through good economic times and bad. However, for those instances when return on investment seems like the impossible dream or your balance sheet looks like a Rorschach test, Embark is here to provide our experience and expertise to help you find your ideal capital structure, through thick and thin.