A Small Business Capital Allocation Guide
In any business (that's any industry, any size, any product), there are generally only 3 ways to use profits:
- Buy more assets (with the intention of growing sales)
- Pay off debt and other liabilities
- Pay dividends to owners
Most finance pros refer to this mix of profit usage as capital allocation.
What does capital allocation actually mean?
Capital is just a fancy word for money, and it can come from a few sources, but mostly cash generation derived by profits and debt or liabilities. Take your total equity and total debt and you have the total capital invested in your business.
In its simplest form, capital allocation is the process of deciding where and how to invest your business’s capital. Through this process we're able to grow revenue and compound business value (i.e. it's important).
Why should you care about this?
In larger companies, this process is formal and highly structured. But for small businesses, capital allocation is 1) a foreign concept not taught anywhere; and 2) usually an afterthought to day-to-day operations and fire drills.
Warren Buffett describes capital allocation as the single most important job responsibility for any CEO... here's what he had to say in his 1987 letter:
They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it's as if the final step for a highly- talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.
What he's saying here — every 10 years (under these conditions) you'll have deployed (i.e. spent) more than 60% of all the money in your business.
For example, let's say your business has $100 in net worth and $100 in debt for $200 total capital. Within 10 years, that total could be $500 meaning you've put $300 to work during that timeframe! A lowly 10% return on that $300 could add another $30 to profits. This adds up quickly...
So how do you use this?
Next week we'll cover a more tactical application of these concepts. Namely: 1) reviewing the sources and uses of cash in your business; and 2) determining your overall return on capital.
For now, let's stick to the main takeaways which are:
- Capital is the money at work in your business (cash flow)
- Capital allocation is the process of using that money
- We can use profits in 3 ways: 1) buy more assets; 2) pay off liabilities; 3) pay equity owners
- Thoughtful capital allocation is what fuels business growth and compounds business value
Tune in next week for some useful tools in assessing your current mix of capital allocation!
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