What is capital allocation and why is it important?

Companies make decisions daily about how to use resources and assets in their business operations and growth plans. These decisions aim to increase equity for owners and shareholders in publicly traded companies. However, decisions about capital allocation are more complex than trying to increase share price or dividend payments. Decision-makers also need to weigh risks, the economic climate and other factors when developing strategies on where to invest a company’s profits. 

Understanding how to allocate capital best and develop effective strategies is important for helping improve an organization’s financial performance. Let’s dive into the role capital allocation plays in business and how employees can apply it in the workplace. 

What is capital allocation?

According to Gartner, capital allocation is “the process of determining the most efficient investment strategy for an organization’s financial resources, with the goal of maximizing shareholder equity.” In other words, it involves choosing how to deploy financial assets and other resources to maximize profits. 

The strategies behind allocating capital cover a wide range of business activities, such as investing in research and development, increasing dividends for shareholders and purchasing smaller companies or assets. 

Capital allocation is often used interchangeably with capital investments. However, allocation typically focuses more on how to use financial resources, while investment is the asset or development project funded by allocation. 

The role of capital allocation in business growth

In simplest terms, when a company reinvests its capital, it can expand its business operations. New products, services, acquisitions or assets spur growth. This expansion can increase profits and, more importantly for the CEO, bring more value to the company. Value is what ultimately drives share prices upward and increases equity, which is the sum of money that shareholders would receive if the organization liquidated its assets and paid its debts. 

Many variables are at play in allocating resources. If an executive decides to put money into one area, it will get tied up there, making it impossible to use if a better opportunity arises elsewhere. 

We can see a prime example of this method within the automotive industry. A major vehicle brand decided to invest in hydrogen-powered cars instead of electric vehicles, which ultimately put it behind its competitors. 

Executives rely on different approaches to inform their capital allocation decisions. They may:

• Look at performance management data to see which area of the company is doing the best and allocate resources to those sectors for further growth.
• Use financial forecasting to help predict how an investment plan will work based on current trends, industry performance and economic data. 
• Rely on specialists, such as management analysts, to decide where to invest in improving company efficiency and performance. 

Economic data or industry forecasts can also play a role in capital allocation decisions. 

5 methods of capital allocation

Since allocating capital can take various forms, most companies don’t simply rely on a single allocation method. It’s essential to understand the different options for capital allocation if you plan to embark on a business career. 

Here are five allocation strategies:

1.    Organic growth

2.    Mergers and acquisitions

3.    Debt payments

4.    Dividend payments

5.    Shares buyback

Here’s a closer look at each method. 

1. Invest in organic growth

Companies invest in organic growth by putting more resources into research and development for a new product or increasing the size of their production or operations. Organic growth is an effort to increase current sales or activity using in-house resources.

An executive can limit risk with organic growth by focusing on activities and departments already performing well. These slow and steady steps are attractive to CEOs who want to limit risk.

However, other methods, such as mergers, offer much quicker growth potential. In a competitive industry, you need more focus on organic growth to stay toe-to-toe with your rivals.

Here are some examples of organic growth: 

• Investing in an existing product: If your company has a successful product in market, you can invest in equipment, facilities and employees to increase production. Increasing the supply could lead to greater profits as long as demand holds steady. 

• Increase marketing: You can also try to reach more customers by increasing existing marketing efforts or developing new campaign strategies to raise awareness of your brand or product. 

2. Mergers and acquisitions

Mergers and acquisitions are methods for increasing the value of a company in the short term. Mergers are when two comparable companies combine their resources and employees and become a new company. 

Acquisitions, on the other hand, are much more common. This type of capital investment occurs when a larger company purchases a smaller one and absorbs it into its operations. A company might acquire another to expand into new industries or areas immediately without going through a development process. 

The primary advantages of mergers and acquisitions are that they lead to immediate growth, expansion into new markets and quick results. However, valuation can be challenging, meaning that the acquisition or merger might not lead to the desired spike in shareholder equity.

3. Pay off debt

Companies often take on debt to expand operations or get through slow economic times. When it earns profits, a company can pay off these loans. This will improve the debt-to-equity ratio, which is an important indicator of overall company health. 

On the negative side, paying debts does not directly improve growth prospects. Depending on the type of loan or bond and interest rate, restructuring the debt may be better than paying it off and forgoing other capital allocation methods. 

4. Pay dividends

Dividends are company profits paid to shareholders. Executives and the board of directors can set the dividend amount, increasing or decreasing it depending on the value of each share of the company. 

Shareholders will often reinvest in the company using dividend profits, which can increase share price further. Investors see dividend-paying stocks as more stable than other stocks, so they are more likely to reinvest. 

Some experts argue that organic growth or mergers will bring more long-term advantages because these methods give a company a better chance to increase the share price with new assets and activities. 

5. Share buybacks

Share buybacks are when the company purchases stock from investors. This method returns cash to investors and also has tax benefits. 

This method is low risk because it keeps equity in the company. Also, unlike dividends, the company gets something in return for its cash payment to investors. Companies then have stocks in hand, which they can sell again to raise more capital. In this way, their finances remain liquid. 

Share buybacks are not without controversy. Buybacks may boost executives’ compensation packages, meaning they may be motivated by personal reasons instead of what’s best for the company. 

Example: Capital allocation strategy

A profitable company will likely use more than one of the five strategies described. Ideally, executives will consider specific criteria when deciding where to place their resources. 

For example, a company in the manufacturing industry may combine several methods to determine the ideal allocation of resources. It may look something like this:

• Organic growth: The company may move some of its profits to purchase new equipment to expand the production capacity for its most popular products. Since it already has the employees, know-how and demand, this option is relatively risk-free. 
• Acquisition: The company may also acquire a smaller manufacturer making a different (but similar) product. The company can then sell or distribute this new product through its normal channels, increasing sales without entering into a new market. 
• Debt payments: Finally, the manufacturer may pay down loans it used to purchase its equipment or materials. This will improve debt-to-equity ratio, increasing share value, and it could free the company to obtain a new line of credit in the future. 

Even though there is plenty to gain in capital allocation, there are challenges to be aware of. 

Challenges to managing capital allocation

Even though capital allocation may seem like it involves risky gambles, companies can also veer toward the opposite side of the spectrum — risking stagnation by not making serious allocation decisions. This is just one of the risks and pitfalls executives encounter when trying to decide on the best use of resources. Here are some other things to be aware of:

• Loss aversion: Executives may want to avoid risks because potential losses could hurt the company and affect the executives’ career prospects. Therefore, they may be tempted to choose the safest methods rather than the ones with the most growth potential. 

• Office politics: Executives may have differing goals. They may want to take the company in different directions, or they could have personal career motives for favoring certain capital allocation methods. 
• Past performance: Executives may choose to compare new allocation projects to previous ones, which could lead to misinformed profit targets. (Previous efforts don’t always dictate future success.) For example, a CEO may think that a certain investment won’t be successful unless it makes the same dollar amount as a previous investment in the same time frame. 

How to learn about capital allocation

Implementing allocation strategies requires a broad range of knowledge. Understanding all aspects of business affected by capital allocation can give decision-makers the best chance of making the right choice. For this reason, aspiring business professionals may want to consider pursuing a degree program that helps provide an educational foundation to develop these plans within an organization.