How CFOs are Rethinking their Capital Allocation Strategy
CFOs are bullish on the post-pandemic recovery at the moment and are looking at overhauling their capital allocation strategy amid the scrutinising eyes of investors, stakeholders, and employees.
COVID-19 inoculations raised hopes for a more permanent easing of restrictions in activities that led to the gradual reopening of key economic activities. A Deloitte survey on the second quarter of 2021 revealed that 41% of CFOs are back on track with the pre-pandemic service demands. 16% have recovered during the second half of 2021, while 43% expect full recovery by 2022 or later. However, if revenue growth is steadily growing, why are CFOs still rooting for a revamp of their capital allocation strategies?
Why is capital allocation important?
Essentially, capital allocation is the process of distributing the company’s financial resources for its short-term and long-term initiatives. It’s the process of assessing the financial viability of different investment options that allows CFOs to foster efficiency and maximise profits and shareholders’ equity through funding of business areas where there are high potentials for fair returns.
CEOs, CFOs, and the management envision allotting their resources in ways that rake in bigger profit as possible. The success or failure of the enterprise hinges on the decisions they will make. For instance, higher-than-threshold income and a consistent influx of positive cash flow can present themselves as a quandary because there are a plethora of investments to choose from. There are options in organic growth, financing mergers and acquisitions (M&A), issuing or increasing dividends, and buying back stocks, among others.
Considered as a black swan event of the decade, the pandemic further intensified the need to make a capital allocation process that withstands a radically transforming future brought by the advancement in technology, changing working environment, and evolving business models. Having a good understanding of the various market changes and how you can adapt to them moving forward bodes well for the company.
If the fund is allotted into the right area, significant benefits await them. Yielding the best results means they also secure the firm’s financial stability for their future endeavours, which is a great win. On the flip side, you must remember that it’s a deliberate path. At unprecedented market conditions, you still run the risk of ending up with deficits. So how do you avoid resulting in a failed capital allocation?
What are the capital allocation methods?
There are five known methods in capital allocation that aid CFOs in deciding on what facet to fund and respond to any potential long-term changes.
Investing in organic growth
This is the basic and straightforward form of capital allocation.
Organic growth is relatively small compared to big-scale enterprises’ growth strategies such as M&A, but it certainly is an important one. It may take a few years for this one to generate returns.
Internal growth is mostly focused on core business efforts. This means the investment is bestowed in you, your people, and the tech you need to solidify your leverage in the competition. Examples include an introduction of a new product, your employees’ upskilling through training, or the research and development for the improvement of your service line.
In a nutshell, it is more of an internal growth by reinvesting the company’s excess capital.
Mergers and acquisitions (M&A)
Unlike the first one, mergers and acquisitions is an inorganic, transformative, but risky type of growth among the five. A lot of executives are careful in doing M&A as its efficiency and value-creating prowess are dependent on the terms of the deal.
To lessen the opportunistic deals that can do value destruction of this strategy, investors want management to set minimum Return on Capital Employed (ROCE) or Return on Invested Capital (ROIC), especially since overpaying for an acquisition is a prevalent practice in M&A. Your acquisition strategy should be clear on your M&A approach and how you maintain your discipline in it. It also helps to have analyses to back up your stances and gauging a myriad of risks carefully to maintain a realistic perspective in your acquisition activities.
Debt reduction is a conservative approach in capital allocation. Having a capital structure that can weather adversities pro tem is good, but you also don’t want to have a balance sheet with all cash and no debts.
A healthy capital is also consisting of a prudent level of debt obligations. With positive cash flow reflecting in your sheet and little to no debt on the other side of the continuum, you are restraining the company in overreaching to rationalise what is comfortable and favourable for your shareholders.
As a strategy, most firms use the EBITDA formula, or Earnings before Interest, Taxes, Depreciation, and Amortization. For most CFOs, 3x EBITDA signals a good point. If you want to take extra precautions, you can set 2x to 2.5x as your standard, but if you go lower than these levels, risks can go higher while reducing shareholder returns. Anything above 3x EBITDA is a good opportunity to deploy capital towards debt servicing.
Also known as share buybacks, this tool can be the most powerful among the five if done properly.
This happens when a company buys back its own shares. It typically happens when the stock prices are high, but 6 to 12 months later or after a recession when large discounts are available and share prices are depressed, the capital devoted to share buybacks dramatically decreases. So instead of being deployed on an as-needed basis, it became a routinary way of returning excess capital to shareholders.
Having a consistent buyback standard- and sticking to it- is a key to this strategy. Regardless of whether the business’ current condition allows it, or if there are no better places to place your capital at that time, you can repurchase your shares. When done right, this can improve important per-share financial metrics (e.g., earnings-per-share, book-value-per-share, and free-cash-flow-per-share).
Dividends are cousins to share buybacks in the sense that they also return excess capitals to shareholders, only that most CFOs still prefer repurchasing shares due to tax efficiency. They create value for investors when there is a steady growth in dividend payments. Having a clear dividend policy elevates confidence that the management has got the revenues and cash flow under full control, along with its predictability.
To fully support the organisation’s dividend initiatives, CFOs must come up with dividend policies grounded on the company’s business model, stability, and long-term visibility of revenue and cash flow.
How is your capital allocation strategy working this 2021?
In the recently published study of EY, 56% of CFOs reported that their capital allocation strategy needs improvement and be completely rethought.
The pandemic impeded planned projects for the previous year. Nevertheless, businesses will have to assess its impact and study the depth of the repercussions in their core operations. Addressing the long-term changes needed from the get-go fuels your agility to achieve your goals, alongside mitigating minute capital constraints along the way.
There will be a reprioritisation in terms of investments, which would hinder long-term shareholder returns. Only 47% of CFOs are confident that their capital allocation process is helping them achieve their total shareholder returns (TSR). If no overhauls are made in your allocation of capital, you risk being left behind in a post-crisis environment where perpetual transformations occur at an unbelievable pace. Having an agile framework that supports this dynamism raises your chances of survival to a higher gear and keeps your head above the water.
Together with the board and the CEO, CFOs are testing different approaches to position their capital allocation and corporate strategy at an optimal level where they collaborate, create high-value, and produce the best outcomes possible.
CFO’s role in capital allocation
Finding the right balance between long-term growth and short-term value creation holds a certain pressure for CFOs, let alone managing it under different market conditions. The capital allocation strategy you deploy will dictate the course of recovery and growth your organisation takes in the event of disruptions. This highlights the importance of having the best team to back up your researches.
To bolster your financial competencies, consider having the best experts to help you guide the business to the right direction. Our Finance Transformation and Workforce Advisors UK offer a comprehensive support solution for modern CFOs like you.
You can also read our Premium CFO Solutions to know how D&V Philippines can deliver solutions that help your finance and accounting processes as the business scales.