Credit Risk Management & Strategic Capital Allocation

2.2 Parameters To Be Looked For Making Strategic Capital Allocation

Market-leading companies not only achieve success through their business results, but also
by properly allocating capital in a way that is most beneficial to shareholders.
A process of how businesses divide their financial resources and other sources of capital to
different processes, people and projects. Overall, it is management's goal to optimie capital
allocation so that it generates as much wealth as possible for its shareholders. !apital
allocation decisions are vital in determining the future of the company and, as such, are some
of the most important responsibilities of company management. "ome of the metrics that
helps in evaluate management's ability to effectively allocate capital in any set of market
conditions.
"hould the company issue or increase dividends# "hould it build that new factory or hire
more workers# $hese are the dilemmas facing managers of today's publicly-traded
companies.
%very company follows a life cycle& in the early stages of life, capital allocation decisions are
pretty simple - most of the cash flows will be poured back into the growing business, and
there probably isn't going to be much money left over. After many years of strong, steady
earnings growth, companies find out that there is only so much market out there to be had. 'n
other words, adding the ne(t product to the shelf, or adding the ne(t shelf for that matter, is
only half as profitable per unit as the first things that were put on that shelf many years ago.
%ventually, the company will reach a point where cash flows are strong, and there is e(tra
cash )lying around.) $he first discussions then can begin about such things as*
%ntering a new line of business - $his re+uires higher initial outlays of cash, but could
prove to be the most profitable course in the long run.
'ncreasing capacity of the core business - $his can be confidently done until growth
rates begin to decline.
'ssuing or increasing dividends - $he tried and true method.
,etiring debt - $his increases financial efficiency, as e+uity financing will almost
always be cheaper.
'nvesting or ac+uiring other companies or ventures - $his should always be done
cautiously, sticking to core competencies.
-uying back company stock.
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Credit Risk Management & Strategic Capital Allocation

Management makes these kinds of decisions by using the same metrics available to investors.
$hese include*
,eturn on %+uity
A stock's return on equit .,O%/ reveals the growth rate of the company in )shareholder
dollars.)
0hen looking at a company's ,O%, there are a few considerations to take into account, such
as the age of the company and what type of business it operates. 1ounger companies will tend
to have higher ,O%s because cash deployment decisions are easy to make. Older firms and
those operating in capital!intensi"e businesses .think telecom or integrated oil/, will have
lower ,O%s because it costs more up front to generate the first dollars of revenue.
,O% is very specific to the industry in which the company operates because each has uni+ue
capital re+uirements& therefore, comparisons should only be made to similar companies when
reviewing this valuable metric. A ,O% above the industry average is a good sign that
management is wringing the most profit possible out of every invested dollar.
,eturn on Assets
Return on assets .,OA/ is similar in theory to ,O%, but the denominator of the e+uation has
changed from stockholder e+uity to total assets. $he ,OA number tells us what kind of return
management is getting on the assets at its disposal. As with ,O%, ,OA figures will vary
greatly within different industries, and should be compared with this in mind.
,OA performance will, over the long run, provide a clearer picture of profitability than ,O%
will. 0hy# -ecause in the ,O% calculations, current net income and last year's net income
are major variables& they also happen to be much more volatile than long-term growth rates.
0hen ,OA is calculated, most of the denominator is made up of long-term assets and capital,
which smooth out some of the short-term noise that ,O% can create. %ssentially, ,O% can
vary widely for a company from year to year, while ,OA figures take longer to change
significantly.
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Credit Risk Management & Strategic Capital Allocation

!apital ,e+uirements and !ash Management
2ividend-paying stocks are attractive to many investors. 2ividends are an effective way of
returning free cash flow to shareholders, and encourage long-term investment in a company.
-y looking at the paout ratio for a stock's dividend, an investor can easily tell what
percentage of net income is being used to pay dividends. $he smaller the payout ratio, the
more room management has to increase this amount in the future. $he most mature dividend-
paying companies are paying out 345, or more, of all the net income to shareholders, which
provides for a nice yield, but leaves very little cash behind to generate future earnings
growth. $hese stocks end up resembling real estate in"estment trusts .a security where at
least 645 of net income must be distributed to shareholders annually/. As a result,
investments in companies with very high dividend payouts will e(perience little price
appreciation. "tock #u#acks are another common way to allocate e(cess capital within an
organiation. 0hen is this in the shareholders' best interests# 'f the company truly feels that
its stock is undervalued, buying back stock could very well be the best use of the funds. $his
will increase the percentage ownership of all the other shareholders, and is generally seen as a
positive sign that management believes in the future of the company.
$he -ottom 7ine
8or the individual investor, part of any effective due diligence should include understanding
the history of, and e(pectations for, the capital allocation abilities of a company. 0hen
looked at along with the "aluation and growth, management's ability to allocate capital
effectively will determine whether it is destined to have a front-running stock, or an )also-
ran.)
,efferences-
Capital allocation t$eor% t$e stud o& in"estment decisions # Gerald A. Fleischer
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Credit Risk Management & Strategic Capital Allocation

'() *F ASS+,(M'(T
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