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OPTIMAL CAPITAL ALLOCATION STRATEGIES: CFOS PONDERING BUSINESS SYSTEMS AGILITY AND RESILIENCE

Byadmin

Oct 24, 2022

What are the functions of CFOs? How do firms determine the optimal capital allocation strategy- best mix of debt, equity, and internal financing that maximizes the return on invested capital? How do firms choose their capital structure? How do firms align and integrate their business  PRA Operational Resilience systems and processes to facilitate learning, coordination, collaboration, and innovation? These strategic questions relate to business systems agility and resilience in disruptive, emergent and dynamic circumstances; and the optimal capital allocation strategies and capital structure of a business enterprise-the appropriate mix of debt and equity that maximizes the return on investment and shareholders’ wealth while minimizing the weighted average cost of capital (WACC), simultaneously.

While disruptions often reveal the potential vulnerabilities of business systems, processes, and procedures, they also provide insights into business agility- capacity for rapid change and for flexibility in operations and resilience- ability to anticipate, recover from disruptions, emergencies, withstand or recover quickly from difficult and adverse conditions. Clearly, effective capital allocation strategy is vital to a sound business strategy designed to maximize the wealth producing capacity of the enterprise. In these series on optimal capital allocation strategies, we will focus on business systems and processes agility and resilience and provide some practical guidance. The overriding purpose of this article is to highlight some key portfolio of CFOs as we ponder industry best practices in business systems agility and resilience. For specific financial management strategies please consult a competent professional.

Some Duties of CFOs

CFOs are responsible for firms’ past and present financial health and constitute an integral part of a firm’s senior leadership in charge of financial management-acquisition and allocation of financial resources. CFOs have multiple duties, that include reviewing and presenting financial statements, planning budgets-cash and capital; and deciding where and when to invest firm’s funds. CFOs design, plan and execute the capital structure of the firm-determine the best mix of debt, equity, and internal financing. Addressing the issues surrounding optimal capital structure and allocation is one of the most important duties of CFOs.

Some Practical Guidance

As I have already explained, while disruptions often reveal the potential vulnerabilities of business systems, processes, and procedures, they also provide insights into business systems agility and resilience. The COVID-19 pandemic was not an exception, it tested the effectiveness of firms’ capital allocation strategies, planning and execution. Firms that were able to quickly re-prioritize investments and re-allocate capital have weathered the storm and, in some cases, even improved their competitive position. But a slight majority of CFOs indicate the COVID-19 pandemic had an overall negative effect on their firm’s ability to efficiently and effectively invest capital in 2020. The apparent lack of agility and resilience in so many firms call for culture of assessment and opportunities for continuous improvement.

Most CFOs indicate the pandemic has forced them to completely rethink their capital allocation strategy, business financial systems, processes, and procedures. There is gathering empirical evidence suggesting that many firms have embraced remote work based on veritable data on productivity. For example, health care providers have fully embraced telemedicine. Many manufacturers have established new health and safety procedures. The question every firm must now answer is which of the many business model changes are strategic and which are only transactional? Additionally, the COVID-19 pandemic has accelerated some trends that were already in place, such as the push into all things digital. In fact, digital technology, which supports trends such as telemedicine and remote working, is the area were CFOs most frequently indicate investment increased in 2020 vs. 2019.

A significant majority of CFOs indicate accelerated digital transformation will impact capital allocation going forward. With so much uncertainty, firms need to weigh the likelihood of various scenarios to determine what their business may look like in the future, and then align their strategy and capital allocation accordingly. CFOs must carefully determine what assets and capabilities they have and need. Once the future state of the firm is carefully assessed, then CFOs must take inventory of the businesses and assets in their portfolio. Systematic periodic portfolio reviews can help CFOs find assets that no longer align with firm’s long-term strategy but can easily be divested to fund future investments.

There is gathering empirical evidence suggesting that the COVD-19 pandemic has forced closer examination of corporate financial portfolios. Indeed, significant majority of CFOs indicate they plan sustained review and rebalancing of their portfolios to focus on the core businesses. Firms should continuously evaluate which assets and capabilities within their portfolio will help enable their future-state business model. Should these assets and capabilities be owned because they are at the very core  PRA Operational Resilience of the business? Could they instead be acquired through partnerships or purchased from third parties, with the trade-off of giving up some control? Many companies are considering these “asset-light” business models that look to source non-core capabilities or inputs into the business through strategic alliances, partnerships, joint ventures, collaborations, or outsourcing agreements.

The goal of evaluating whether your firm is the best owner of each asset is to free up capital to invest in the capabilities that will be core to the business enterprise in the future. Funding future portfolios requires a capital allocation process with governance that instills discipline and enables unbiased decision-making. The process must also be agile enough to adapt to changing business needs. But many CFOs indicate their capital allocation approach is not adequately flexible and regularly updated nor informed with necessary data. Therefore, the business financial systems and processes should be systematic, deployed and integrated to facilitate learning, innovation, and continuous improvement.

There is material empirical evidence suggesting that even when the process is systematic, more than a simple majority of CFOs indicate their capital allocation process is not always followed. Consequently, less than half of CFOs indicate they can quickly assess market threats and opportunities and reprioritize planned investments accordingly. This can hinder long-term shareholder returns as only slightly less average number of CFOs indicate their capital allocation process is successfully helping them achieve their Total Share Return (TSR) goals-a measure of financial performance, indicating the total amount an investor reaps from an investment-specifically, equities or shares of stock. In practice, TSR factors in capital gains and dividends when measuring the total return generated by a stock. The formula for calculating TSR is { (current price – purchase price) + dividends } / purchase price. TSR represents an easily understood metric of the overall financial benefits generated for stockholders. Therefore, TSR is a good indicator of an investment’s long-term value, but it is limited to past performance, requires an investment to generate cash flows, and can be sensitive to stock market volatility.

Process Alignment and Integration

Extant academic literature and best industry professional practices suggest that in firms with aligned and integrated business systems and approaches, operations are characterized by repeatable processes that are routinely evaluated for continuous improvement. Learning is shared and there is deliberate coordination among all business units. Further, processes adhere to key strategies and goals and are regularly evaluated for change and continuous improvement in collaboration with various business units. The firm so aligned and integrated seeks to achieve efficiency, quality, innovation, and customer responsiveness across all functional areas of the business enterprise through analysis, innovation, and sharing of information and knowledge management designed to create and maintain competitive advantage in the global marketplace.

Processes and measures track progress in key strategic and operational goals. Aligned and integrated processes require consistency among plans, processes, information, resource decisions, workforce capability and capacity, actions, results, and analyses that support key system-wide goals and strategic priorities. Effective align­ment requires a common understanding of shared purposes, critical functions, and goals. It also requires the use of complementary measures and information to drive planning, tracking, analysis, learning, innovation, and continuous improvement at all levels. Effective alignment and integration require harmonization of plans, processes, and knowledge management to support key system-wide goals. Therefore, effective integration goes beyond alignment and is achieved when the individual components of a firm’s performance management system operate as a fully interconnected unit. Functional adaptability is the measure of matured business systems and processes.

Agility and Resilience

Best industry professional practices suggest agility and resilience require business leaders to know, understand and anticipate emergent business challenges, stay flexible to adapt to shifts in the global marketplace and initiate change in their firms. It’s the dynamic business enterprises that have a much better chance to survive – and even to thrive – in the shifting global business environment. Further, agility and resilience relate to the firm’s ability to plan, anticipate, prepare for, and recover from disasters, emergencies, and other disruptions, and protect and enhance workforce and customer engagement, supply-network and financial performance, firm’s productivity, and community well-being when disruptions strike.

Additionally, resilience requires agility throughout the firm and goes beyond the ability to return to status quo ante when disruptions emerge. In practice, resilience means having a plan in place that allows the firm to continue operat­ing as needed during disruptions. To achieve resilience, business leaders must cultivate the agility to respond quickly to both opportunities and threats, adapt strategy to changing circumstances, and have robust governance with a culture of trust. Agile and resilient firms adopt an ecosystem mindset, embrace data-rich thought processes, and equip their workforce with ongoing learning of new skills and align business systems around critical functions.

By admin