Perspectives on Capital Allocation

Businesses can at times deprioritize where it allocates its cash flow, but it is foundational to some of the most impactful decisions a management team makes.Management teams should allocate their capital with the following framework:

1. Fund strategic alternatives

2. Ensure adequate liquidity

3. Deleverage to optimal capital structure

4. Distribute excess cash to shareholders

Because companies have a finite amount of capital, strategic spend in these categories should be under consistent review in order to maximize growth opportunities and shareholder value.

Reinvesting in the business is essential for facilitating growth and enhancing profitability, which leads to value creation and attractive returns for investors. Examples of strategic alternatives include investing in new equipment, purchasing a building or making an acquisition. The return on any investment should exceed a company’s cost of capital or internal hurdle rate. Investments that generate a return greater than the cost of capital will be accretive to the overall business.

Liquidity is defined as cash and short-term investments plus the amount of revolver availability. Lack of liquidity is more likely to cause financial distress than excess leverage. The key question to answer is what level of liquidity is needed to manage through a down cycle. Key metrics such as growth, margins and cash conversion will each have an impact on liquidity. Sensitivity analyses can help show where the business may be vulnerable. For companies going through a significant growth phase, upsizing the revolver may be necessary to accommodate incremental working capital requirements or support other corporate purposes.

The optimal capital structure is different for every company, but there are a few methods that can help you assess whether deleveraging the business is appropriate. A comparable company analysis can help managers compare their capital structure to their peers (acting as a guideline versus the “correct answer”) by evaluating debt to equity and debt to EBITDA ratios. Similar to determining adequate liquidity, it can also be useful to stress-test EBITDA to see how leverage is impacted and whether the business can continue to pass financial covenants. Lastly, companies should look at their weighted average cost of capital, or WACC. This is used not only as a minimum hurdle rate for investment opportunities, but also to consider the proper mix of debt and equity in the capital structure. Since the cost of debt is lower than the cost of equity, a certain level of leverage can lower the WACC, which in turn increases value.

After a company has invested in growth and strengthened its balance sheet, excess cash can be distributed to shareholders in the form of a dividend or stock buyback. While dividends serve as an important source of interim liquidity and return for a shareholder, they should occur last in the line of priorities as they represent a “nonproductive” use of dry powder. The opportunity cost could be expensive if a company chose a dividend over an alternative that would enhance the overall profile of the business and provide a greater long-term return to shareholders.Capital is a limited resource, and well-managed companies will be in the habit of:

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  Prioritizing investments that offer a return in excess of the company’s hurdle rate to strengthen the business and increase shareholder value.

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  Ensuring adequate liquidity to protect against a downturn.

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  Assessing the optimal capital structure to ensure dry powder is available for future opportunities, establish a lending relationship and help optimize a company’s cost of capital.

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  Distributing excess cash to shareholders

Firms with the proper cash flow prioritization will maximize shareholder value and strengthen the company’s future.