Capital Allocation

Companies consume resources in order to create value-added product or services. If they become successful, they will retain cash from their conversion of resources. In this sense, the role of management in companies is threefold:

  1. As financers: The management has to source the resources that it needs for its operations.
  2. As operators: The management needs to convert those resources profitably.
  3. As investors: The management has to allocate the excess capital from operations.

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Management as Financers

To achieve its goals, the management of a company needs to gather the resources the company needs for operations.  There are five main types of resources that management can source:

  1. Shareholders Equity
  2. Debt securities
  3. Hybrid securities
  4. Negative working capital
  5. Off-balance sheet resources

Management as Operators

The most conventional manner in which companies convert resources is by converting raw materials into value-added products that are then sold for profit. By that logic, these companies consume resources to create earnings.

Earnings-Based Businesses

Usually, when a company aims to increase its sales, it will need to consume more resources. If the management of a car rental company is going to increase its sales, it generally will need to acquire more cars.

There are, however, certain businesses that are less dependent upon consuming raw material to create earnings. In some cases, companies can collect revenues before they convert any resources.

Negative Working Captial Businesses

These companies have, what is called, a negative working capital. When Richard Branson started Virgin Airways, the company was already accepting payments for tickets before it made a single flight.

Cinema houses, normally receive access to films from production companies and start selling them. They only pay the production companies based on sales after the sales period. Insurance companies collect insurance premiums from their customers and pay out claims later.

Free Cash Flow Business

Theoretically, the ultimate example of a Free Cash Flow business is an asset management company. An asset management company manages investment assets for third parties, by performing research and acting on that research on behalf of its clients. Assuming that the companies investment universe is sufficiently large, the company would not need to perform additional, if assets under management grow.

Asset management companies generate earnings by charging management fees, which are a percentage of assets. So, if the AUM grow tenfold, the additional earnings from management fees will be almost entirely free cash flow to the company as the company does not need additional raw material for the additional earnings.

Management as investors

When companies operate successfully, they retain earnings from their operations. When a company retains earnings, its management will have to decide how to allocate the capital that operations have accumulated. The management will have 5 main options when it comes to capital allocation:

  1. Investing the capital into the business
  2. Acquire new assets or operations
  3. Pay down debt
  4. Payout dividends
  5. Buyback its stock