Capital allocation is a process typically owned by the CFO. From the CEO’s perspective, allocating capital is one of the most important strategic financial decisions they make that underpins the organization’s prospects for long-term growth and success. As for the board, directors are stewards of capital deployment. As such, one might say that the process of allocating capital is the CFO’s ultimate touch point with the CEO and board.
The capital allocation process touches critical financial decisions, including returning cash to shareholders (dividends or share buybacks), debt reduction and mergers, acquisitions, and divestitures. But it is much more ubiquitous than that, as it encompasses major decisions to drive and sustain organic growth, whether from capital expenditures, R&D, new product introductions, new systems, reallocation of internal resources, and determination of working capital levels.
What a difference a few months make
While the traditional modus operandi of capital allocation has remained theoretically sound over time, the circumstances in which the process and the related models are applied today have changed. The pandemic has altered many assumptions. Digital technology advances can entail “do or die” investing in some industries. Talent acquisition and retention have been transformed. Flexible labor models are being deployed. Customer loyalty isn’t the same as it once was. Supply chain just-in-time efficiency models don’t work anymore. Disruptive change is the norm. Resilience is the key to surviving and thriving. Instinctively, CFOs are recognizing the importance of enhancing the capital allocation process as they face this evolving new normal.
As they work through their capital allocation planning processes amid uncertainty about the coming year, many CFOs are recognizing how quickly external economic conditions—and, in response, corporate strategy—can pivot. In addition to reevaluating cash flow planning and current portfolios of capital expenditures, finance leaders should consider making adjustments and improvements to their long-term and working capital allocation processes in response to economic headwinds. As time progresses, the odds of those headwinds turning into a global recession are increasing.
Another current challenge is the emphasis on stakeholders versus shareholders. For example, given the increasing demands of stakeholders of all kinds, some CEOs and CFOs are developing “ESG disclosure fatigue” as they focus on navigating the business to keep it afloat through choppy economic waters. The capital allocation process can instill discipline in boardroom conversations with its focus on purpose, prioritization of scarce capital, measures of return on invested capital and accountability for results. The CFO can facilitate this discipline.
Then there are rising interest rates, which in turn increase the cost of capital. In light of the specter of continued aggressive interest rate hikes by central banks, board members, CEOs and other executive leaders are seeking more granular insights from the CFO about the organization’s capital projects—a major use of allocated capital. They are asking questions which affect, and are affected, by both long-term and short-term capital requirements, such as:
- What product or service lines should we get out of now?
- Which products and services will prove recession-resilient?
- What will it cost to build a new production line and supporting operations?
- What is the revenue opportunity and long-term economic value added?
- What is the payback period?
- What is the carrying cost?
- What is the adjusted targeted rate of return?
CFOs need to be prepared to answer, in a compelling and succinct manner, these and other questions stemming from a changing economy and inflationary trends.
In addition, capital investment plans tend to cover years rather than months. Given how dramatically the cost of capital has increased over a brief period of time, previous capital allocation plans require a comprehensive reevaluation. CFOs should take the lead in performing this scrutiny by reassessing different dimensions of CapEx investments and plans, including:
- Costs and payback periods: The CFO and finance group should revisit and update cost and other assumptions to reflect recent and ongoing increases to input costs such as labor, materials and interest rates. They also should take a fresh look at customer demand and assess how those projections may prolong the time it takes to generate target profitability levels and the expected return on investment.
- Corporate strategy and competitive opportunities: Every CFO knows that capital allocation plans need to be aligned with corporate strategy. But is the plan updated concurrently with adjustments to the strategy? The CFO is responsible for calculating what it costs to execute both short-term and long-term strategic objectives—as well as the opportunity costs associated with delaying or permanently shelving investments. Accordingly, the most effective reevaluations of capital allocation plans extend beyond costs and short-term returns to consider longer-term benefits. For example, what is the benefit of an investment that has a strong likelihood of driving a competitor out of a key market?
- The investment cycle: Pinpointing where a capital project is in its investment cycle also leads to better allocation decisions. Consider this scenario: If the construction of a new plant is 60% complete, shelving that project may not be an option. If, however, construction has yet to begin, that project can be delayed provided the cost of carrying the land is not excessive.
Given changes in the marketplace, CFOs and finance leaders should evaluate opportunities to upgrade their capital allocation processes. The following actions can yield significant improvements:
- Increase the frequency. Prior to the current downturn, most capital planning efforts were conducted on an annual basis or less frequently. But the pace of change is necessitating a shift. The CFO should have formal mechanisms in place to track changes in assumptions, risks and opportunities continuously throughout the year. A plan to deploy capital midyear may need to be delayed, scrapped or redirected to another project based on what occurs during the first half of the year.
- Expand data collection. When allocating capital, many companies tend to rely too much on internal data. As allocating capital is typically about increasing efficiency and optimizing profits, finance groups with leading processes pull in far more external data that they analyze in combination with internal data. Useful external data points include market share, housing and real estate costs, commodity costs, and other industry and business factors likely to influence customer spending. Without an external perspective, the process becomes an academic application of arbitrary assumptions.
- Sharpen storytelling. Storytelling is an increasingly valuable CFO skill. The CFO should be mindful of the manner in which information is communicated to the board regarding capital allocation (preferably on a quarterly basis). This requires establishing context by reconciling external market data with the business strategy and then citing select data to provide a rationale for making changes to previous investment decisions.
- Strengthen accountability. The rising tide of favorable interest rates, prices and economic conditions over the past decade lifted all ships. Now that the tide is receding, suboptimal cost management practices—which, until recently, were masked by cushy profit margins and low-cost access to funding—are coming to light in many companies. For example, as CFOs and finance leaders put CapEx investments under their microscopes, they should look for revelations related to cost management shortcomings. This will reinvigorate efforts to enforce accountability for the execution of capital projects.
The fluid, interconnected nature of current macroeconomic and geopolitical conditions requires CFOs to embrace a more dynamic approach to capital allocation. Boards want to hear from CFOs about how CapEx investments have been re-evaluated in response to changes that have occurred in the past few months. They will expect finance leaders to quickly calibrate new capital plans as needed throughout 2023. They will want updated assessments of capital structure to optimize debt and equity financing. For CFOs, adopting a more frequent assessment of capital allocation decisions, leveraging an expanded data set to support decision-making, communicating effectively with directors and executive leadership, and building in greater accountability across the enterprise will help pave the way forward amid an uncertain and complex economic outlook.