The Smart CFO's Handbook of Capital Allocation

CFOs are constantly weighing the company's resources, return on time and human capital against company health and shareholder value. So why should CFOs pay attention to capital allocation now?

One reason is that recent global crises have forced companies to change their capital plans on the fly. Some companies were able to change, but many were unable to because they didn't have a working plan. 

In addition, environmental, social and governance risks and activist shareholders force many executives to anticipate long-term strategic implications. For example, finance leaders should consider the impact of these challenges on critical investments, such as how climate change will affect new manufacturing facilities in vulnerable regions of the world.

Additionally, government tracking and implementation of new tax regimes will have a significant impact on how much and how quickly businesses can leverage tax equity for their capital investments.

Yet capital allocation is not just about achieving higher returns with less spending. It's about measuring the return on internal investments and maintaining the cash flow that enables those investments. 

Proper capital allocation gives companies a real edge over their competitors. In this post on CFO insights, we explore how better capital allocation decisions and an appropriate strategy can help bridge the gap between profitability and growth.   

Key Takeaways:

• With so many allocation options to consider, better-than-expected earnings and positive cash flow often present a dilemma for CFOs.
• Three key elements of smart capital allocation include diversification, insight-based technology and growth, including a balance of investments and paying operating costs. 
• In capital allocation, remember to review trends and begin small, building upon each decision. 
• Don't use buzzwords and fancy lingo in communicating with shareholders regarding critical capital allocation decisions. Use simple terms and be precise and concise.

What Smart CFOs Know About Capital Allocation

Better-than-expected earnings and positive cash flow are desirable in and of themselves, but with so many allocation options to consider, they often present a dilemma for CFOs. 

Some capital allocation options may include returning cash to shareholders through dividends, repurchasing shares, issuing special dividends or increasing research and development (R&D) budgets. 

Alternatively, companies may choose to invest in growth initiatives. This may include spending on acquisitions and organic growth or finding ways to expand operations.

Regardless of how you allocate capital, maximizing shareholders' equity (SE) is often your top priority and determining which allocation provides the greatest return always presents a challenge. 

The question to ask yourself would be, is there a better strategy? 

3 Key Elements of Smart Capital Allocation

Before we discuss the three elements of smart capital allocations, keep in mind that you cannot set anything in stone. 

The market changes rapidly and a well-thought-out strategy for today may prove catastrophic in the future. 

That's why we recommend reviewing and revising your capital allocation strategy regularly. Companies that continually evaluate their allocation strategies and adjust them accordingly are worth more and assume fewer risks than companies that do not. 

Along with reevaluating your allocation strategy regularly, focus on these three elements of capital distributions:

1. Diversification

Liquidity is a nearly guaranteed aspect of any market, and ultimately the uncertainty that this fluidity supply makes investment diversification so critical. 

Unfortunately, current trends for many organizations are to simply pile large amounts of capital in the same place instead of diversifying to reduce risk and boost returns.  

                                                                Source: The Financial Wellness Blog

2. Insights

Smart capital allocation requires data-driven insights. The right FP&A software solution offers a strategic perspective of long- and short-term financial goals, economic growth trends, stock market data and more. 

All organizations√¢‚ǨÔøΩ - especially those that haven't been operating for long√¢‚ǨÔøΩ - can improve their financial futures with insights from FP&A software that helps their business manage capital allocation. 

3. Growth

Capital allocation inevitably involves decisions regarding trade-offs. Organizations must find the right balance between investments that serve the long-time needs of the business, those that drive growth and those that carry a higher risk but have the potential for high returns.

Capital Allocation Do's and Don'ts 

Capital allocation can be tricky to navigate if you haven't been doing it for long. As the CFO, knowing what to do (or not to do) when it comes to allocations requires prudence. First, review trends that similar organizations follow regarding capital allocation. 

The CFO in the scenario depicted by the chart below determined that 50% of capital allocation should go towards breakout systems. They have allocated only 5% of the company's cash and the remaining 45% for options trend following capital allocation. 

Notice the CFO here focused their strategy on growth and maintaining profitability, not paying returns to stakeholders. Invest back into the business or plan for future instability.

                                                                             Source: Theta Trend

Notice the CFO here focused their strategy on growth and maintaining profitability, not paying returns to stakeholders. Invest back into the business or plan for future instability.

While the above example does seem a bit simplistic, keep in mind that when you begin developing a capital allocation strategy, the best practice will be to keep money in the company, spending it in ways that foster long-term stability and profitability.

Now that we have covered the do's, let's review some of the things you want to avoid with these capital allocation don'ts: 

• Don't Confuse Conventional With Conservative: Just because something's common doesn't make it the best or safe decision.  
• Don't Ignore Base-Rate Probabilities: Don't torture a spreadsheet to rationalize your decisions. 
• Don't Assume You're Right Because Others Agree:  Capital allocation requires critical thinking, so be skeptical when making decisions, even when people agree with you.
• Don't Use Buzzwords and Fancy Lingo: In communicating with shareholders regarding critical capital allocation decisions, use simple terms and be precise and concise.
• Don't Do Things That Don't Make Sense to You:  Regardless of who is doing them. 

Make Better Capital Allocation Decisions With Vena

Build better budgets with smarter capital allocation. Simplify the process and plan for your company's financial future with confidence,  knowing you're working with a leader in FP&A insights.  

With Vena, track variances between allocation periods and use this data to make informed allocation strategies. A detailed audit trail ensures transparency and accountability, giving you 100% control over your number. 

Excel at Real-Time Allocations

Tedious processes are a thing of the past with Vena. Our allocation software integrates directly with your general ledger, eliminating the need to manually enter journal entries. Vena's plan templates have allocation rules that suit your organization, making it easy to allocate funds to different departments with a single click.