Secrets of the best companies for cash allocation: one question for financial executives who have survived the liquidity crisis is what to do with excess cash. Here are five steps that will enable corporate leaders to best allocate their resources.Excess cash deployment is back on the agenda for most large public corporations. Despite helping their companies survive one of the most pronounced liquidity crises in living memory--and doing so by being prudent and holding on to cash--financial executives are now concerned about what to do with excess cash.
Unfortunately, many finance teams do not have all of the requisite tools to support cash allocation decision-making effectively. They tend to make several common mistakes:
* Deliver capital planning presentations that are too complex and do little to educate decision-makers on the company's true risk appetite;
* Use different criteria for each cash allocation decision so it becomes difficult to weigh the relative pros and cons; and
* Fail to distinguish between types of cash. For example, cash "trapped" overseas has a repatriation cost attached to it and takes longer to access.
One result of this lack of clear guidance into cash avail-ability and the relative merits of different allocation options is often what can be referred to as "cocktail party decision-making." In the absence of clear guidance from finance, the chief executive or board of directors use other Information at hand to inform a decision, like benchmarking versus other companies in the industry or banker advice. Both are useful sources of information but should not be used independently of the financial goals and limitations of the company.
The root cause of these mistakes at many corporations is the belief that cash allocation is a financial problem and should sit with finance. Capital allocation decisions impact most senior managers and all investors; these stakeholders should share in the vision for how the C-suite intends to boost returns on capital.
As such, capital plans and how they are communicated need to be tied to clear goals that reflect the interests of the beneficiaries, whether they are business managers, board members or investors.
Over the course of the last decade, the Corporate Executive Board has worked with thousands of senior financial professionals to determine how the best companies and their executive teams tackle common problems. When it comes to allocating cash, the best executive teams get five things right.
They use a rolling liquidity plan to create a shared C-suite/board vision for risk tolerance.
A good liquidity plan takes a long-term view, is refreshed periodically and establishes optimal liquidity based on business risks and opportunities that are recognizable throughout the company.
Based on CEB's research, a few techniques work well. The first is a cost/benefit model. The cost of holding additional cash is a function of financing and opportunity costs; the benefit of holding cash is a function of the reduced probability of distress.
Another good approach used by leading treasury professionals is based on a survival horizon. Headline liquidity is placed on a timeline under multiple scenarios, demonstrating how the company would respond under each and how long it would survive.
For example, "For six months in this scenario, we will need a $650 million buffer." Such simple, rigorous approaches leave very little room for ambiguity and guesswork.
They make capital availability and deployment part of the same plan.
Prior to the financial crisis, it was fairly common to find most parts of the capital planning process sitting solely within corporate finance. The liquidity plan was a complex snapshot of cash and short-term debt positions. At many companies, capital structure reviews were often conducted in a vacuum, separate from the broader strategic concerns of the company.
Capital was cheap and plentiful and there was little need to bring liquidity risk to the attention of the chief executive and board on a monthly basis because it wasn't likely to change. And then it did.
In 2010, the capital planning approaches of more than 100 global corporations were surveyed. "Confidence In financial risk tolerance" was used as an output variable against which the impact of multiple financial planning disciplines was tested. The highest-ranking planning traits are those where the liquidity plan is tied directly to other processes.
For example, the plan feeds directly to enterprise capital planning or strategic scenario analysis. Using a single capital allocation framework for all decisions is also tightly correlated with higher visibility into risk tolerance. By taking a disciplined, long-term view of the availability and the uses of capital, ambiguity is reduced regarding its deployment.
They consistently relate cash decisions hack to strategy using a common, recognizable framework.
Using a "single version of the truth" for allocating capital provides clarity for business managers into the requirements business plans have to meet, and why one plan has been judged superior to another.
Critically, it provides the board and senior management with a better under-standing of the trade-offs they are making when they choose one option over another--whether pulling the trigger on an acquisition or holding on to the cash to wait for a better opportunity.
One of the clearest models was identified at a pharmaceutical company. This organization uses a six-step process to allocate all capital, from acquisitions to share repurchase decisions. These steps are: STRATEGY ALIGNMENT--Specifically, which strategic goal will the project help the company fulfill?
LIFE-CYCLE CAPITAL REQUIREMENTS OF THE PROJECT--Beyond the initial upfront investment, what ongoing maintenance or support will the project require?
OTHER RESOURCES REQUIRED--In addition to the upfront capital investment, what human and technology-based resources will the project require? THREE "NEXT-BEST" CAPITAL ALLOCATION OPTIONS--which opportunities are we turning down by funding this opportunity?
P&L AND CASH FLOW IMPACT--will the Investment be accretive or dilutive to the Income statement?
ROIC FORECAST VERSUS THREE-YEAR BUSINESS TARGET. All projects are evaluated side by side on a matrix that includes three variables: return on invested capital (ROIC)--the company's headline strategic measure; net operating profit after taxes (NOPAT); and the capital requirements of the project.
They distinguish cash sources and costs.
Many companies make the mistake of treating all cash as equal. By failing to differentiate between the sources and costs of cash, senior management and investors harbor poor assumptions about the appropriate levels of liquidity and financial risk tolerance (e.g., "cash earned in foreign markets is equally available as domestic cash," or that "capital from financing has the same value as cash from operations," or "if it's cash--it's liquid").
To avoid these assumptions, audit the location of cash and recognize the relative cost of deploying cash sitting in different locations in management reports. Make the distinction as to whether cash is allocated for operating or financing purposes, trapped over-seas or reserved for investments or pension liabilities
They communicate the Capital plan to investors.
A lack of clarity around business fundamentals, such as availability of cash and allocation strategies, are core drivers of investor uncertainty. In a more volatile economy, many investors are less concerned with which cash allocation strategy a company adopts and more concerned about understanding the strategy and rationale behind senior management's decisions.
Finance executives who don't provide this level of clarity run the risk of leaving investors to make investment decisions based on poor assumptions about future business performance. With only 40 percent of investors and analysts claiming to understand corporate performance drivers, they are willing to pay (on average) a 17-percent premium for the clarity that companies can provide around strategy.
To avoid poor investor assumptions, share core elements of the company's capital allocation strategy, highlighting cash availability and cash priorities and communicate how your allocation strategy drives shareholder value (see Figure above left).
It is rare to find all five of these cash allocation tactics in place at the same organization, yet many chief financial officers and treasurers are moving in the right direction--toward greater discipline in capital planning.
Tim Raiswell (email@example.com) is a senior research director in the Finance Practice of the Corporate Executive Board, a corporate research and advisory firm in Washington, D.C. Michael Griffin, Thomas Roberts and Alexander Rossaiso contributed to this article.