Leading market companies efficiently allocate capital to maximize shareholders wealth. Management is responsible for allocation of capital and also for achieving business objectives and goals. We will have a look at how management can lead towards accomplishment of its goals by capital allocation.
Change an Essential Need for Business
Today’s mangers are faced with certain questions about taking decisions like dividends must be increased or issued. Would it be favorable to induct of new workers and new plant?
Every company goes through life cycle stages. At very early days capital allocation decisions are very straight forward. Cash flows are mostly reinvested into business. No idle or extra money is left over. But with the passage of time, firms earnings grow steadily and extra money or funds left over. Then management thinks about extension of business. They decide to adopt in a new line of business. Initially cash spending is high. But it could be beneficial for company in future. This will run like same until declining trends hit growth rates.
Management makes the decision about issuing or increasing dividends, repaying loans or promises and investing decisions, repurchasing own stock etc. These decisions involve the use of Return on Equity and Return on Assets.
Measure Of Growth-Return on Equity
Growth rate of company is indicated as the profits gained by shareholders. When we consider the ROE we have to look at certain factors i.e. company’s age and business type.
Companies new to the industry or market usually have higher ROE. The reason behind this is that they have no problem to make cash operating decisions. Industries have their own capital requirements so each industry has specific ROE. If a company’s ROE is above than industry’s average ROE then company is making most out of its investments from the industry. ROE can be calculated as under.
ROE = Net Income / Total Equity
Asset Use Efficiency-Return on Assets
It indicates how much earnings company makes by asset utilization. It provides a better idea about company’s performance. ROE takes two variables into account (current year net income and previous year net income). If we compare them with long term growth rates they are more unstable. ROA mostly takes into account long term assets and capital. ROA is calculated as under.
ROA = Net Income / Total Assets
Capital and Cash Management Requirements
Suppose Company A has average of 20% ROE during first 12 years of its operations. Indeed it has strong growth record. It was during the initial years of company when more new markets were available. Company A realizes that it can not continue with this strong growth rate and high market share, so it adopts other methods to benefit shareholders. It sets aside capital requirements to keep business running. For the purpose of durability and consistency firm evaluate free cash flow. If it is done then management takes initiative to best utilize these funds.
Investors are attracted by the dividend paying stocks. Free cash flow is returned to shareholders by dividends. Long term investments are encouraged by dividends. Pay out ratio tells that how much is paid in the form of dividends. Mature companies pay out 80% of net income as dividends. Firms repurchase own stock to allocate extra capital within the firm. If the stock is undervalued then repurchase of stock is considered as the best utilization of funds. It is a positive sign to shareholders as their ownership percentage will go up.
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