A CFO’s Guide to Capital Allocation Decisions
Capital allocation can be the make it or break it point of a company. After all of the hard work, the revenue is finally in and now an important decision needs to be made: How will the financial resources be distributed in a way that will maximize the company’s profits and increase its efficiency, while keeping the balance of generating wealth for its shareholders?
Although these decisions are ultimately up to the CEO, the CFO plays a crucial role in capital allocation by building a strategy that supports long term growth.
Avoid Stock Buybacks
Although there are situations where stock buybacks are beneficial, Covid-19 and the volatile market have shown that there are more disadvantages to this than advantages. However, this lesson may have been short lived. After bottoming out at $89 billion in Quarter 2 of 2020, buybacks have increased to a record $223 billion in Q3 of 2021 from S&P 500 companies alone.
The temptation to perform stock buybacks with extra revenue is appealing both for tax reasons and because it increases the earnings per share, making investors happier with their value.
However, this “short term temptation” should be left to bigger and well established companies, according to many market experts. Proof of the risk can be seen in the airline industry where airlines such as Delta, United, and American, spent 96% of their capital on stock buybacks in the years leading up to 2020. When the pandemic started, they had almost no cash on hand, which resulted in major government bailouts to save the industry.
Even though these are huge and well established companies, they had very little to do when they were caught with nothing on hand due to the buybacks. For now at least, experts suggest to keep cash in the business in order to spend it in other ways that will foster long term company growth and stability.
Be open with Stakeholders
Going over the data in a detailed way and from multiple angles will help you and the company make better decisions, while publicizing the results and being open with stakeholders will reward you tremendously as well.
As a CFO trying to determine the everyday goals and cash flow, building a top-down portfolio view of financial, risk, and strategic issues will give a clear picture of how potential scenarios ladder up to everyone who is part of the company.
Doing this will prove transparency to the stakeholders and strengthen the tie between strategy and capital decisions. The CFO has the ability to bridge the gap between executive decisions and the stakeholders. This is done specifically by graphing the top-down model and evolving the project portfolio management in an analytical but transparent way. Those who have the ability to do this will propel the company forward by pinpointing exactly what the goals are, and most importantly, they will gain the trust of the stakeholders.
Transformative Business Allocation
“New isn’t always better”, but when the time for transformation comes, pushing it off will only worsen the situation in the long run. When transformation turns into a priority, there is no better time to execute it than during capital allocation.
Whether it’s transformative business deals, rethinking the company’s investment strategy, or cost restructuring, the company needs a clear transformation goal to show the investors. Capital allocation is a good time make the announcement, and it is up to the CFO and FP&A teams to put together enough data to prove how and why the transformation plan will benefit the company.
A Boston Consulting Group survey showed that only 24% of companies who went through a significant transformation were able to produce higher Total Shareholder Returns in both the short and long term when compared to similar industries. Since TSR is one of the most important aspects looked at by investors, it is up to the company (led by the CFO) to produce the data that will prove why this transformation is necessary, both for the sake of the stakeholders and the company in the long run.
No such Thing as too much Project Analysis
This is essentially a combination of everything talked about so far, as projecting different outcomes will put the CFO in a better and more informed position to execute the capital allocation plan. From bridging the gap between the company executives and investors, to leading the financial team, to both simplifying the data and analyzing it more in depth, the job description of the CFO seems never ending during capital allocation decisions.
Instead of using typical IRR calculations which won’t produce all of the data needed to make capital allocation decisions, the financial team must go through all of the possible analysis and scenarios. Scenario testing, projections, past performance, comparing to similar industries, and worst case scenarios, are some examples of the way the CFO can cover as many angles as possible to ensure that the plan has the best chance to succeed.
Producing all of this data, especially when considering that it will be shown to investors, executives, and company members, means that time and FP&A solutions are key. Using software tools will save a lot of time by combining pre-existing data, which will leave more time for analyzing the company’s capital allocation decisions.
Implementation is an Ongoing Process
After deciding which capital allocation process is best for the company, the job is not over for the CFO. The financial team needs to follow through on the implementation and make sure that everything is on track, or make adjustments where necessary.
An important aspect for the CFO is making sure that there is a Plan B for flexibility and change when possible. Although that is true in general, it applies even more so when the company is going through transformation as well.
Lastly, post-mortem reviews will help determine what went right and what needs improvement when looking back on the capital allocation process. You never know when new decisions will need to be made and learning from the financial team’s strengths and weaknesses will only make it easier in the future.
To sum it all up, capital allocation brings the company to an extremely important crossroads. The CFO has a lot of work to be done and needs to know how to balance it all, including pressure from all of the different parties involved to produce the best results. These tips will help a CFO not only get through the capital allocation process, but also propel the company to the next level.