Chapter 1
Define your future and your investment road map
As capital spending rebounds, companies must decide which investments best support their strategy.
How will your company deliver long-term value to your stakeholders? And how will your capital allocation strategy enable you to reach those goals?
The pandemic tested the effectiveness of companies’ capital allocation strategies, planning and execution. Companies that were able to quickly re-prioritize investments and re-allocate capital have weathered the storm and, in some cases, even improved their competitive position. But more than half of CFOs say the pandemic had an overall negative effect on their company’s ability to effectively invest capital in 2020.
Most CFOs say changing customer demands (60%) and an inability to accurately forecast future business performance (54%) are the most challenging business issues they have faced during the pandemic. Other issues like supply chain disruption and softness in the end-consumer market are prevalent in specific sectors.
Looking ahead through 2022, CFOs expect their investing to rebound (Fig. 1.). The key is how to decide on the best areas to focus that investment. This poses challenges especially when many companies do not have the capital to fund all their projects, future customer demands and competition may change rapidly, and the metrics by which companies are measured keep evolving.
Define the future state of the business
Most CFOs say the pandemic has forced them to completely rethink their capital allocation strategy or process (Fig. 2). Health care providers have embraced telemedicine. Manufacturers have established new health and safety procedures. Many companies have embraced remote work. The question companies now need to answer is which of the many business model changes will stick and which are only temporary.
At the same time, the pandemic has supercharged some trends that were already in place, such as the push into all things digital. In fact, digital technology, which supports trends such as telemedicine and remote working, is the area were CFOs most frequently say investment increased in 2020 vs. 2019 (Fig. 3), and 62% say accelerated digital transformation will impact capital allocation going forward.
With so much uncertainty, companies need to weigh the likelihood of various scenarios to determine what their business may look like in the future, and then align their strategy and capital allocation accordingly.
Determine what assets and capabilities you have and what you need
Once the future state of the company is envisioned, the next step is to take an inventory of the businesses and assets in your portfolio. Regular portfolio reviews can help companies find assets that no longer align with the company’s long-term strategy but that can be divested to fund future investments. The pandemic has spurred a closer look at portfolios; more than two-thirds of CFOs say they plan to rebalance their portfolios to focus on the core business.
Companies should then evaluate which assets and capabilities within the portfolio will help enable their future-state business model. Should these assets and capabilities be owned because they are at the very core of the business? Could they instead be acquired through partnerships or purchased from third parties, with the trade-off of giving up some control? Many companies are considering these “asset-light” business models that look to source non-core capabilities or inputs into the business through alliances, partnerships, joint ventures or outsourcing agreements. The goal of evaluating whether your company is the best owner of each asset is to free up capital to invest in the capabilities that will be core to the business in the future.
Communicate the strategy to key stakeholders
Sharing the capital allocation strategy with stakeholders is essential. Amid rapid change, companies need support and buy-in from employees who will be the drivers of the company’s growth journey. In fact, 69% of CFOs say they communicate their capital allocation plans with employees (Fig. 4).
However, there appears to be room for improvement when it comes to communicating with the investor and analyst community — only 55% of CFOs say they communicate their capital allocation strategy with these stakeholders. A lack of transparency can erode trust. When companies execute their capital allocation strategy, investors should understand the investment decisions being made and how these will enable the company’s future success.
Key takeaways
Chapter 2
Use the capital allocation process to drive business agility
The capital allocation process should instill discipline, while allowing flexibility.
Funding the future requires a capital allocation process with governance that instills discipline and enables unbiased decision-making. The process must also be agile enough to adapt to changing business needs. But many CFOs say their capital allocation approach is not flexible and regularly updated nor informed with necessary data. And even if the process is established and well documented, more than half (53%) say their capital allocation process isn’t always followed.
As a result, less than half of CFOs say they can quickly assess market threats and opportunities and reprioritize planned investments accordingly. This can hinder long-term shareholder returns — only 47% of CFOs say their capital allocation process is successfully helping them achieve their TSR goals.
Changes in customer demand and behavior, uncertainty over the pace of the post-pandemic recovery, difficulty in developing forecasts, and the need to decide which changes spurred by the pandemic are permanent and which are temporary all point to the importance of continuous improvement in the capital allocation process. While most (67%) note that they review their capital allocation process annually, only 8% perform postmortem reviews and regularly analyze how the process needs to be changed. Given the speed of market change, companies should be striving for a capital allocation process that continually evolves.
Establish proper governance
To drive sound and timely decisions, a company’s capital allocation approach should be underpinned by a governance structure that strikes the right balance between being both formal and objective but also not so encumbered with rules and processes that it impedes a company’s ability to move quickly from ideation through implementation.
Leadership should align on a shared vision that ties the process back to strategy, identifying the strategic goal that is supported by the investments being made. Is the company trying to drive growth? Be more sustainable? Enable innovation?
Aligned on a common goal, each business unit should use the same framework and similar metrics to make capital allocation decisions. This allows projects to be evaluated consistently across the business and should help eliminate personal bias. Unfortunately, more than half (53%) of companies say their processes or investment criteria are applied inconsistently.
Leadership alignment on goals and metrics early in the capital allocation process avoids the need for various guardrail processes and improves performance and agility.
Follow up on implementation
The capital allocation process does not end when decisions are made. During implementation, CFOs and their teams should verify that the assumptions made around the investments are proving out or require in-flight adjustments.
After implementation, governance should also call for postmortem reviews to determine what went right or wrong and then incorporate those learnings into future investment decision-making.
CFOs say their process framework and governance (56%) and project monitoring and look-back (54%) are only slightly or not at all effective (Fig. 5). These challenges can hinder agility during changing market conditions, leaving companies unable to pivot when needed.
Consider the human element
People and corporate culture are key elements of successful capital allocation but are often overlooked. Having the best business cases, decision models and prioritization frameworks cannot drive success without personal accountability — and executives’ freedom to acknowledge failure.
Project owners should be evaluated on project success and the reliability of business case assumptions. The level of reliability should also inform future investment decisions. For example, if the head of a segment repeatedly underestimates costs in business cases, that executive’s business cases need to be risk-adjusted going forward.
Certain projects may require high levels of personal interaction to develop a common purpose and achieve success within the organization. These may require integration partners or other influential leaders to incorporate new capabilities and assets into the larger business. Project owners should have a clear implementation plan to verify that new projects dovetail into existing structures, projects and work streams.
At the same time, project owners should be empowered to cancel an underperforming project and allow the capital to be redeployed, instead of trying to save the project with inefficient workarounds to avoid realizing the loss.
It is critical to develop a shared definition of “winning” throughout the organization that does not hinder agility when circumstances change.
Use advanced tools to gather and analyze data
Companies are being evaluated on more metrics than ever before, both quantitative and qualitative. It’s no longer just a matter of revenue and profits but also the social and environmental impact of their decisions. Misfiring on any of these metrics can imperil earnings, corporate reputation and long-term value creation.
With the plethora of data that must now be considered, it’s no wonder that lack of data access (52%) and lack of data analysis capability (42%) are among the most cited barriers to optimal capital allocation (Fig. 6). In fact, lack of access to data is up 11 percentage points from when we asked CFOs about similar barriers to success in 2018.
The more data being collected, the more time and effort it takes to analyze it accurately. Some tools just don’t bring the firepower needed to manage and analyze the vast amount of data.
Companies need to employ advanced data and analytics tools to manage the broad spectrum of metrics and produce usable insights, including highlighting any issues that need to be addressed immediately.
Automation tools that can pull various internal and external sources of data into dashboards can help speed up the process and lessen the possibility of human error. Analytics software can reveal data points that are essential for decision-making, and data visualization tools can help provide actionable insights.
Key takeaways
- Establish proper governance to drive consistent decision-making across businesses.
- Follow up to confirm that decisions are being implemented effectively, make in-flight changes if necessary and conduct postmortem reviews.
- Consider the human element, instilling personal responsibility and allowing the freedom to acknowledge failure and correct mistakes.
- Leverage data and advanced technology to increase decision-making efficiency and effectiveness.
Chapter 3
Focus on the right metrics in the post-pandemic era
The way companies are evaluated is changing. The right quantitative and qualitative KPIs are key.
Data management and analytics tools are only as good as the information that goes into them. CFOs note that a host of metrics have become more important in the capital allocation process in the past year, with qualitative metrics leading the way (64%), but quantitative metrics following closely behind (61%) (Fig. 7). This may be an indication that the disruption from the pandemic is forcing more rigor in decision-making and that a broader set of stakeholders (employees, customers and regulators in addition to the board and investing public) is demanding to understand more about the rationale behind each decision.
Certain metrics have become more important over the past year, with many tailored to the specific strategic needs of an industry. Nearly three-quarters of advanced manufacturing executives, for instance, say quantitative metrics have grown in importance, while for health care payers, qualitative metrics have come to the forefront. Sustainability is growing in importance for all industries, but especially in life sciences (Fig. 8).
A balanced scorecard approach, combining financial metrics with quantitative nonfinancial metrics (e.g., efficiency and yield) and qualitative metrics (e.g., regulatory risk, people impact), is the most effective way to strike this balance.
Track the right KPIs of long-term value
As the definition of long-term value has expanded to include not only financial value but also customer, people and societal value, companies are striving to identify and measure the right KPIs to evaluate their performance across these categories. In selecting KPIs, CFOs need to understand what is most important to the company’s success and to its stakeholders and determine how to measure it.
CFOs are well aware of financial KPIs such as growth rate, free cash flow and return on invested capital. But other KPIs are increasingly critical. Among those that could be considered are:
- Customer value – satisfaction, trust and loyalty, and brand value
- People value – engagement, employee loyalty, leadership, diversity and inclusion, and health and wellness
- Societal value – sustainability, total economic impact, carbon footprint, water consumption and ethics
There are a host of other metrics that can be measured. For example, the World Economic Forum’s International Business Council, with support from EY leadership, has proposed a set of common metrics to spur sustainable value creation. The key is to choose the KPIs that align with the company’s long-term strategy and mission statement in order to make capital allocation decisions that support the aspirational future state of the business.
Quantify qualitative metrics
CFOs in the EY survey named qualitative metrics such as safety and regulatory requirements, workforce impact, and alignment with corporate strategy as the most common qualitative measures they consider in their investment decision process. The impact on diversity or social goals and sustainability are also becoming increasingly important. However, a common concern related to qualitative metrics is that they can be subjective.
With the advancement of digital technologies, more and more qualitative aspects are becoming measurable (e.g., social media engagement). In the absence of having a completely unbiased quantitative method to measure, a balanced scorecard approach can incorporate qualitative factors. In the absence of quantitative data, qualitative metrics can be assigned a weighting, creating a data point or “score” that can be included on the balanced scorecard and utilized in the evaluation process.
Providing a consistent framework for the qualitative assessment of individual investments helps decision-makers compare alternatives.
Regularly review and refresh KPIs
Backtesting can help sort through the myriad of available qualitative and quantitative metrics to determine which KPIs actually drive value, based on the company’s strategic goals. Executives should look for past correlations with the results the company is trying to achieve and use those to inform decisions.
Companies should also regularly evaluate KPIs. As the pandemic showed, the future is uncertain, and the business environment can change without warning. Make sure your KPIs keep pace.
Key takeaways
- Choose KPIs that reflect the company’s long-term value creation strategy.
- Use a balanced scorecard and assign weight to qualitative KPIs.
- Regularly refresh KPIs to make sure they still align with the long-term strategy.
Use your capital allocation strategy to drive long-term value
While the pandemic’s impact on individual companies has been unique, most executives agree that it has driven a renewed focus on capital allocation. CFOs have found they need to look beyond the bottom line and take a more holistic view of capital allocation, incorporate effective data management and analysis, and focus on building trust with stakeholders through effective communications.
In the current business environment, there is great opportunity to improve the capital allocation decision-making process. Striking the right balance between rigor and agility will enable companies to achieve their long-term strategy and value creation goals while navigating short-term disruptions.
Summary
Chief financial officers are recovering from the upheaval of the COVID-19 pandemic, which underscored the need to develop a capital allocation process that promotes long-term growth even in the face of short-term disruption. In our survey of 1,050 CFOs, more than half said their capital allocation strategy needs to be completely rethought. CFOs need to ensure that their capital allocation strategy promotes growth, that their process supports the strategy, and that they are using the right data and tools to make decisions.
