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The importance of capital allocation

What is capital allocation?

Capital allocation is the management decision regarding what to do with the funds the company has at its disposal.

Prior to that, the company has had to generate funds one way or another, say by operating profits, by borrowing money, by issuing (selling) new shares to the public or by divesting in the business (for example, selling a business unit), among others.

Then, comes the capital allocation decision: what to do with said money. So, what’re the options?

Capital allocation alternatives

  • To invest the funds in the business, for example when the enterprise tries tto grow, or to improve efficiency. It can buy fixed assets (say, more or better equipment), or invest in working capital (by lending money to customers who buy on credit, by raising inventory levels to support sales, or reducing payables by paying suppliers). Buying fixed assets is usually called Capital Expenditures (Capex).
  • To use it to buy a new company or business unit altogether from a third party. In this case we’re referring to inorganic growth, growing by instantly buying new revenue venues (as opposed to organic growth, which is growing the business -sales- the company is already into). Acquisitions can be counted on the inorganic category.
  • It may choose to decrease debt levels, by giving money back to its lenders (be them banks or corporate bond creditors, etc.), not only to fulfill its obligations, but also to decrease interest payments in the future.
  • Finally, to reward its own investors, whereas by dividend payments or by repurchasing shares from the stockholders at capital markets.

Why is capital allocation important?

Capital allocation may influence heavily on the final destiny of the company, so it’s paramount to have a sound financial policy.

For example, if the firm can buy assets which generate better return (in terms of profitability) than the cost to get the money required to buy the assets (say the interest level charged by the bank), in principle it would be wise to do so, as the return generated from the investment in said assets will more than pay the interest due (what’s called financial leverage), netting an excess cash inflow for the company, which could then be used to pay a dividend to stockholders or any other use. Of course, the firm should also be able to earn the cash in time to repay the loan, for it to make sense.

On the contrary, if the firm is already too leveraged (it has huge amounts of debt which require most of the funds generated), it may be wise to try to repay it quickly, to gain more financial freedom. Interest expenses are fixed expenses, and companies that are heavily leveraged are in a weaker stance when recession comes and profits are at risk of turning to losses (because of lower revenues). Additionally, if the interest rate paid on said debts is high enough, liquidating assets with a lower rate of return would make sense (called deleveraging).

Asset pruning should also be considered, in which wise management make a conscious assessment of low return assets, and look for ways to dispose of them, to get money to either buy better return assets, service high-cost debt, or give it back to the stockholders so they can look for their own better-return opportunities. A company shouldn’t hang on to a low return asset indefinitely, unless it’s strategic (but truly strategic, not wishful-thinking strategic), or it has concrete expectations to improve its performance in the future. Many cases are documented of turnaround firms that improved their financial performance by continuous asset pruning, greatly increasing shareholder value in the process.

Considerations should also be made regarding whether to give money back to investors, and how to do it. In general, if the firm has great expectations of investing funds in a very profitable investment, it should keep and use the funds, benefiting the stockholders in the long run, by increase the stock value. If the other scenario is true (the firm has only low-level return possibilities) it should give the cash back to investors (which may have better options on their own).

As to how to give money back to investors, there’re two common alternatives, either dividends or share repurchases. In both cases the company gives away cash to stockholders. Is it the same to do it one way or the other? Not necessarily, because there may be tax considerations. Say for example, if tax legislations levied heavier dividends than repurchases, stockholders would get most by the latter that by the former. What you don’t get in term of dividends you get in terms of stock price rise (and you may also sell a small proportion of your holdings to virtually create your own desired dividend policy).

Cash hoarding and capital allocation

Some firms are sometimes criticized as “cash hoarders”, of accumulating too much funds, with no apparent use, and advisors urge them to do something profitable with it. While that may be true (said funds could be generating next to nothing in returns for the moment, so there’s an opportunity cost), sometimes it’s useful to have that much cash. Think of when a depression comes, panic is spread and stock prices get battered, and a very solid firm gets to buy a competitor at a bargain price (because it had the cash available when others didn’t), creating enormous value for its stockholders (who may be now more at ease with all the past “hoarding”). If done properly, through acquisitions a company may increase its revenues and profits overnight (inorganic growth), and therefore its future funds generating capabilities. In this sense, flexibility attained may be a strategic value.

“Cash hoarders” have also extra flexibility in time of bear markets. When stock prices start to get beaten, these companies have more ammunition available to repurchase their own stock, both improving Earnings Per Share (EPS) and helping damp falling quotes.

An interest metric to consider for these cases, is what percentage of the outstanding shares the firm could buyback at current prices using its net financial position (cash and equivalents, plus financial investments minus financial debt)

Finally, another reason why “cash hoarders” might be attractive as investment is that, for a company to be able to hoard cash, it has to own a profitable business to begin with. If the funds were earned in an organic way, then it’s the living proof that the firm has shown genuine fund generating capabilities in the past.

Key takeaways (TL;DR)

  • Capital allocation is the process by which a company decides where to invest the funds obtained. Either by reinvesting in the business, buying another company, repaying financial debt or rewarding shareholders.
  • Interest rates paid and return of assets are two important metrics to consider when choosing to increase or decrease debt levels (leverage).
  • A healthy dose of asset pruning goes a long way in shareholder returns, while analysis should be made if dividends or share buybacks are the better way to pay stockholders.
  • Just as an investor needs to be wise with his money (like you or me), companies should also be smart about it too. How to get it, how to use it.

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