Why CFOs need a capital allocation framework
CFOs are the linchpin of any good capital allocation strategy and will have the most influence over its design. But how do they help ensure the development of a strategy that’s fit-for-purpose?
Determining how to allocate capital is arguably one of the most complex responsibilities facing CFOs today. The process of generating and deploying capital is core to the CFO role and key to producing outsized return on capital — but also one that is quite difficult to perform well.
Internal agendas, volatile market conditions, and human biases all cloud the decision-making process. With boards and institutional investors increasingly expecting management to provide clarity on how capital will be deployed to achieve strategic goals, having a robust capital allocation strategy that guides and explains investment decisions is vital.
However, according to a global Deloitte survey of business leaders, only 22 per cent claim to be very confident in the ability of their capital allocation approach to execute the organisation’s overall strategy and optimise return on capital.
This disconnect between expectations and reality has consequences. The absence of well-structured capital allocation framework can lead to suffocation of value creation, suboptimal returns on shareholder capital, and, at the extreme, companies can expose themselves to activist investor pressure or opportunistic takeovers.
I recall the case of an SaaS company whose management team could not decide whether the business should allocate additional capital to sales and marketing to chase growth, or double down on product development to improve long-term retention and pricing power.
Without a framework to guide them, progress stalled, and ultimately, private equity (who are typically very skilled at capital allocation) acquired the business. The lesson is clear: failing to actively manage capital allocation doesn’t mean the decision goes away. It might just be made by someone else.
As keepers of the corporate purse, CFOs are the linchpin of any good capital allocation strategy and will ultimately have the most influence over its design. But how do they help ensure the development of a strategy that’s fit-for-purpose?
It all starts with asking the right questions, clearly and consistently, like: what is our strategy and where is capital needed to execute strategy? What is our strategic asset allocation across the business? For a diversified real estate group, this might mean sector exposure or geographic mix. For a miner, it might relate to commodity exposures. Visibility over where your capital is deployed and the alignment to strategy is a perquisite for intelligent decision-making.
Next you could ask what your mandatory capital investments, across both operating and capital expenditure, are. Things like safety upgrades, regulatory compliance or maintenance capex are all essential spends that must be prioritised before discretionary investment. Doing this helps see how much capital there is to work with.
Grouping capital needs into categories like maintenance, optimisation, transformation, and growth can also help teams evaluate options more clearly.
CFOs must also define what level of gearing is acceptable and understand how it impacts the cost of capital and appetite for risk. Determining the right level of gearing can be difficult, but scenario analysis is essential, particularly in times of uncertainty. You need to understand the potential impact of volatile trading environments on your business and ability to meet debt covenants, as well as implications on refinancing risk.
Equally important are the company’s commitments to shareholders and having a clear understanding of what shareholders expect from the business. Dividend policies, reinvestment promises, understanding shareholders’ support and appetite to fund growth and share buyback schemes are all part of the capital equation. Sometimes the best use of capital may be to return it to those who have placed their trust in the business.
Portfolio performance should also be reviewed regularly, and not just when considering new investments. It is important to remember that capital allocation is not just about the deployment of capital — staying invested in existing assets or businesses is a capital allocation decision too. CFOs should ask whether where their capital is invested continues to be consistent with strategy, maximises shareholder value and whether they are the best owner of the asset or business.
By adopting a portfolio approach, companies can spread risk intelligently. For instance, when most of the portfolio is weighted toward stable, low-risk investments, a company can afford to place selective, higher-risk bets on innovation or market expansion.
Alternatively, when volatility is high, organisations can dial back risk exposure without halting growth altogether. This type of strategic flexibility is only possible when capital is actively managed.
These questions and considerations are not exhaustive but are central to developing a strong capital allocation framework and all the benefits that come with it. But in my view, the best capital allocators also embed a return on capital mindset into their organisations’ culture, which guides daily decision-making at all levels of the organisation.
The top-performing CFOs foster an organisational mindset where capital is treated as precious, where each dollar invested must be producing returns for the business aligned with long-term goals.
This more mature approach also allows for a more integrated view of financial and non-financial objectives — like environmental, social and governance (ESG) concerns. For example, there is often tension between investing in sustainability and delivering immediate shareholder returns (although I would argue that delivering shareholder returns in the long-term cannot be done without ESG in mind).
Good capital allocation frameworks don’t solve that trade-off, but it does make it more visible. It allows for a conversation about how ESG forms part of capital allocation decisions and how capital allocation can promote ESG agendas which form part of an organisation’s strategy.
In many ways, company management has never been more scrutinised than it is today. CFOs who fail to take a rigorous approach to capital allocation risk falling short of market and governance expectations. Those who embrace it as a core leadership discipline can unlock tremendous value for the organisation and its shareholders.
A well-structured capital allocation framework doesn’t just help organisations decide where to invest. It helps companies align human capital with strategy to deploy scarce capital in the areas that achieve greatest return for shareholders and other stakeholders. In an era of constrained resources and heightened scrutiny, that kind of clarity is essential.
Aleks Lupul is Lead Partner for Deloitte Capital Allocation, Modelling & Insights.
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