The Importance of Proper Capital Allocation

Businesses have faced several challenges since the start of the coronavirus pandemic, including supply chain issues, inventory shortages, and high levels of employee turnover. To ensure companies successfully combat these problems, business leaders must find ways to turn a profit and diversify revenue strategies and market value.

They can accomplish this by implementing proper capital allocation strategies, which increase efficiency, maximize profits, and compound shareholder wealth. Managers with free cash flows—the amount of cash a company generates after accounting for debt, operation expenses, and assets—should allocate capital to improve the business’s bottom line.

Why is capital allocation so important to an organization’s success, and how do you choose the best capital allocation strategy? Below is an overview of what capital allocation is and how you can maximize its value.

What Is Capital Allocation?

Capital allocation is the distribution, re-distribution, and investment of financial resources to maximize stakeholder profits. It’s a strategic financial decision made by chief executive and chief financial officers that’s critical to a company’s long-term success.

Many executive teams consider available investment options—such as providing shareholder dividends, purchasing stock shares, investing in growth initiatives, or increasing research and development budgets—and analyze the effects each has on the organization to ensure profitability.

Why Is Capital Allocation Important?

There are plenty of value creation opportunities, but it’s important to know your options before making important financial decisions.

Companies are holding more cash than ever before. In fact, 13 non-financial companies in the S&P 500 are sitting on more than $1 trillion. Some of these companies include:

• Apple: $202.6 billion
• Alphabet (Google): $169.2 billion
• Microsoft: $132.3 billion

Having a large amount of cash means companies can repurchase their stock, provide dividends to shareholders, and determine how to handle investors wanting returns. These financial decisions significantly impact organizations, investors, and the economy—all of which are critical to a company’s future success.

5 Ways You Can Allocate Capital

There are many ways to allocate capital successfully. Here are some of the most common strategies leaders leverage to better position their company for long-term success.

1. Invest in Organic Growth

Organic growth refers to a company using its capital to expand or streamline its business operations. To invest in organic growth, companies optimize their internal processes, offer new products, or re-allocate resources to new departments.

For example, restaurant chains may purchase more property to open additional restaurant locations. Or a cosmetic company might invest money into their research and development (R&D) department to create clean products.

Leaders measure their company’s organic growth by comparing revenue year over year.

2. Acquisitions and Mergers (M&A)

Instead of using capital to expand internal operations, companies can acquire or merge with other businesses with these resources. While this can often yield results quickly by bypassing internal growth, it can be a risky way to allocate capital.

Risks can include:

• Lack of due diligence: Prior to a merger or acquisition, a company must thoroughly research the business opportunity, financials, contracts, and insurance. Without this process, companies can inherit obligations it’s not yet ready to assume, such as litigation issues and tax matters.
• Overpayment: Some organizations rush to close a deal, leading to overpayment for the merger or acquisition. This can be a major obstacle when trying to create value.
• Miscalculating synergies: Business leaders can overestimate the ‌time, effort, and money required to integrate two workforces.
• Integration issues: During an acquisition or merger, operational and cultural integration issues can arise. It’s important to have a robust integration plan that addresses both companies’ values, cultures, assumptions, and operations.

3. Pay Off Debts

Businesses must know their finances, especially when it comes to debt. This crucial accounting information is included in financial documents, like the balance sheet. Leaders must be able to read, and analyze, these financial statements to both identify a company’s debts and provide possible solutions for payoff. For example, companies can use excess cash to pay off debts to improve the debt-to-equity ratio and ensure the business is healthy.

4. Pay Dividends

Another way to allocate capital is to pay share dividends, which distributes profits to shareholders. The payment amount is usually determined by the board of directors and includes a proportional increase or decrease in stock price.

Investors value dividends since they return free cash flow to stockholders and promote re-investment into the company. Paying dividends is also a good sign that the company is financially stable. According to Investopedia, the most stable companies over the past several decades have consistently paid dividends to its shareholders.

5. Share Buybacks

Some organizations may use capital to buy back their shares from the marketplace to reduce outstanding shares, reinvest, improve their financial ratios, and make existing shares more valuable to stakeholders.

A company can buy back shares through the open market or a tender offer—an offer to shareholders to tender a portion, or all, of their shares within a period. Since issuing a share buyback is often perceived as a positive indicator of a company’s success, stock prices generally increase in value.

Does Capital Allocation Make a Difference?

Allocating capital indicates an organization is healthy, successful, and worth investing in and often leads to compounded shareholder wealth.

Facebook, Apple, and Google are great examples of the success companies can achieve when capital is properly allocated. Investors and business leaders shouldn’t overlook how important capital allocation is for both the business and the market. Poor strategic decisions about capital allocation can lead to a decreased return on equity, lower stock prices, fewer business opportunities, and stagnant growth.

Do you want to learn more about capital allocation and how it can help your company achieve long-term success? Check out Leading with Finance—one of our finance and accounting courses—to learn how to make sound financial decisions for maximum profit.