The capital allocation process must change. Without an efficient approach, organisations will fail to benefit from long-term value creation.
Businesses across industry face unsettling factors such as sector convergence, geopolitical uncertainty and technology fuelling important changes to consumer behaviours. These factors are forcing companies to evolve rapidly. However, in Morshona’s experience, a company that embraces a proper, methodical approach to capital allocation will be better positioned to obtain value from this trouble and have the flexibility to quickly assess new investment opportunities that emerge.
Without an efficient approach to capital allocation, poor investment decisions can result in low shareholder returns, financial underperformance and increased pressure from shareholders. Nevertheless, Morshona has seen that a number of leaders admit that their capital allocation process should be improved.
Key areas where companies can adapt their capital allocation strategy and deliver value creation in a rapidly evolving economy.
To drive maximum value in this ongoing period of uncertainty and interruption, effective capital allocation should support business strategy and maintain enough flexibility to adjust when the need arises. However, a number low than the median of only 43% of Leaders say that they can change their capital allocation approach quickly enough to consider new opportunities and modify pre-planned investments.
Information is not the end of the story
Despite technological advances, 42% of Leaders say that insufficient information is a primary barrier to the ideal allocation of capital. Given the speed at which organisations are evolving, businesses must seek new ways to understand what drives profitable growth – and then find ways to acquire information to measure these key drivers.
Acquiring this information is not the end of the story. If a company cannot use this effectively, they will have to rethink the tools it is using to analyze that information and answer the insights it contains. Information visualization tools can not only help identify trends and value key drivers, but also greatly increase stakeholder engagement.
A refined analytical process for decision making is an essential pillar of a successful capital plan
Freeing up cash
In addition to robust data analytics, the ability to reallocate capital is vital to enable flexible decision-making.
Some companies have strong cash cultures, where they value cash flow and do not tie up capital in unproductive areas like underperforming or noncore business units, or in certain geolocations where moving or repatriating capital is structurally difficult. These businesses have the advantage of using their cash resourcefully, and in a time of uncertainty and rapid change, this ability to move fast will be important for resilience.
Managing risk
Agility enables a business to quickly react to new opportunities or threats and may entail taking on higher-risk/higher-return investments that can help organisations become interrupters, rather than being interrupted.
Morshona believe that holding high-risk, high-reward investments – either at a company level or in an internal project capital arm – can act as defence against concerns about short-term losses for business unit executives whose financial incentives may be affected. About, 43% of Morshona’s clients agree that such investments are owned at the company level, while 26% agree that they are proposed and owned by the company’s project capital fund. However, one-quarter state that all approved projects, regardless of risk, are owned by the business unit that requested them.
A business that leads a cash flow culture is empowered to move quickly toward new opportunities
Other liquid businesses approach to maintaining flexibility while taking on risk has helped to adapt to convergence and disruption in the oil and gas industry. The mixture of investments from lower risk acquisition and higher risk, put potentially higher return partial ownership of the organisation and that it is possible to maintain a flexible approach to capital allocation while maintaining a strong balance sheet. Over the past five years, the organisation annual total shareholder return of 15% was approximately 300 basis points higher than the average of its peer group and the ASX 200.
Trust is earned when organisations establish a track record of successful execution and when they are transparent with shareholders on not only specific capital investment initiatives (such as developing a new product line, making an acquisition, or improving information capabilities), but are transparent with their investment selection process and how they strategically allocate capital. If stakeholders see a company as cautious stewards of capital then they will give you more of an opportunity to invest for the long term.
Objective and fact-based, involving extensive analysis and input from industry experts and participants, as well as from our shareholders. The business thorough analysis earned broad approval, particularly from prominent futuristic shareholders who were especially pleased with the detailed portfolio review.
The reaction from the futuristic shareholders demonstrates how detailed analysis, combined with effective communication, is fundamental to building trust between an organisation and its shareholders.
By adopting a high level of discipline around how capital allocation decisions are made, C-suite, board and shareholders stress can be significantly reduced, and trust among key stakeholders significantly improved.
Eight leading practices for allocating capital
Guidance on how to create a consistent approach to capital allocation through eight prominent practices.
Focus on a small number of metrics that reveal an exterior perspective and tie directly to creating shareholder value.
Engage reliable evaluation criteria and objective processes for all investment decisions.
Create a “cash culture” that awards cash flow and does not tolerate unnecessarily tying up capital.
Take a zero-based budgeting approach to arraying capital.
Practice continuous improvement by investigating each investment and implementing lessons learned.
Entrench stress testing across capital allocation to strengthen resilience.
Bring into line capital allocation, strategy, and communications.
Maintain information systems that generate grainy information.
The right decisions need a connected strategy
Companies that align their management incentives, long-term strategy, and investment evaluation criteria increase in value. However in reality not most businesses have that alignment.
Morshona believes that tying reward to cash flow and other measures of long-term value creation, rather than solely focusing on earning per share (EPS) or accounting metrics, can foster long-term thinking throughout the organisation. These types of incentives, along with embracing a culture of value creation and continuous improvement from the C-suite and throughout the business, are key ingredients in the recipe for sustainable growth and total shareholder return outperformance.
Earn the trust of investors by showing you are an effective steward of capital.
Overall, getting capital allocation right is important to driving, rather than derailing sustainable growth. A more poor approach to capital allocation can not only result in reduced growth and lower value creation but also makes the company more vulnerable to a hostile acquisition.
To build confidence in strategic decisions and drive growth and resilience, fostering a strong cash culture, focusing on making unbiased decisions based on vigorous analysis and building shareholder confidence will help drive a capital allocation strategy that can generate attractive returns for investors while maximizing value creation.
For more information on capital allocation, managing risk and strategies talk to Morshona advisory team
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