Does the company have a rational capital allocation policy?
Updated: May 11
What is capital allocation? In simple terms, it is how intelligently capital is invested. When a promoter starts there is a certain capital that needs to be allocated and once that allocation is done, the business starts to earn a return on that capital. In the case of a business that is growing at a decent rate with a high return on capital, it will generate a lot of cash flow.
As the company is generating more and more cash flow it is the responsibility of the management to make use of that cash flow. Capital allocation decision is all about how that cash flow is being used.
A company that has a lot of debt, as the cash flow increases this company should ideally reduce the level of borrowing. Look at companies that are continuously reducing their borrowing.
Reinvestment back in the business
A company may also use cash flows to set up a new plant, get into a new business, or get into a new geography, or product. The management must ensure that the returns with any new activity increase and so does the cash flow.
A company has the option to acquire another company and use the excess cash. Often acquisition is not a value-creating opportunity. Rather these acquisitions are used by the management to increase their power.
Hold cash in the balance sheet
A lot of companies that generated decent cash flows in the year 2020 did not give away the cash. The reason was the uncertain business environment. It is alright for a company to hold cash for some time, but it is not okay if the cash held is for the long term. Any cash kept on the balance sheet reduces the return.
A company can decide to give away the cash flow in the form of a dividend. Do not assume the company that pays a dividend is good. If a company can use cash flows and deploy them back into the business and generate a higher return and thus a higher cash flow, that is better. However, if the company does not see opportunities, it is fine to distribute dividends.
A company may decide to reduce its public equity by buying its shares from the market. Do not assume that companies buying their shares are great companies. If the management is not smart, they may buy when the share price is high, and this creates a suboptimal return for the existing shareholders.
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