By CFO Brew Staff
less than 3 min read
Definition:
Remember that lemonade stand you had as a kid, and all those warnings about not spending your money in one place? And remember how it felt when hours and hours of hard work turned into $5 of candy you consumed in approximately 30 seconds? That was capital allocation gone wrong.
Capital allocation, or how companies raise, spend, and redistribute money, is about avoiding those throw-it-all-away moments. The goal of capital allocation is to maximize long-term value and efficiency for the organization and its shareholders.
How capital allocation works
Of course, no one, except Cousin Billy, who already spent his whole allowance, would recommend blowing all your cash on a stockpile of candy. But C-suites are faced with much trickier decisions for allocating their capital, where all options seem viable yet some will yield better results than others. In a sense, capital allocation turns high profits and positive cash flow into a quandary: more options, but more opportunities to squander them as well.
Some common examples of capital allocation include moves like share buybacks, investing in mergers and acquisitions, using share dividends to return cash to shareholders, or bolstering R&D budgets.
How to effectively analyze capital allocation
You could write a book (and there are plenty) on how to analyze the best capital allocation opportunities at a given time for a given company. More fundamental, however, is a simple understanding of why that kind of analysis matters in the first place.
In a memo on capital allocation results, assessments, and key principles, Morgan Stanley experts pointed to two key reasons why companies should primarily use capital allocation to drive long-term shareholder value.
Why is capital allocation important?
For starters, any company that allocates capital effectively will compete better in the market compared to organizations that mismanage resources. Additionally, there’s the matter of opportunity cost, or “the rate of return they could earn on the next best alternative. Capital that fails to earn the cost of capital over the long term destroys value and imperils a company’s prospects for prosperity,” Morgan Stanley experts wrote.
Sounds a bit like blowing $5 on candy purchases.
