Capital Allocation — What Is It?

The two main goals of the management of any company are to run the company profitably and efficiently allocate earned income and other capital to generate maximum value. So, capital allocation is very important. But what does it even mean?

What is capital allocation?

Capital allocation refers to how the management of a company spends the capital it earns, generates, or borrows. As you know, a company’s capital comes from income, borrowing, or equity. It is the primary duty of the management to allocate capital efficiently so as to maximize both long-term and short-term income.

For most companies, the capital gotten from borrowing or issuing equities is already planned for specific projects or operations, even before it is raised. The one that is often difficult to manage is the income from the day-to-day operations of the company.

For example, a company that, on average, has been making a 10% return on invested capital for 10 years would have to plan how to allocate 61% of its present total capital.

Wondering how the 61% of total capital came about? Consider this: a 10% return for ten years means that the initial capital has now grown to 259% of the 100% it was 10 years ago. That is, it has earned an income of 159%.

This 159% income represents 61% of the present total capital of 259%. Managing this income efficiently to generate value is what distinguishes the management of the company.

Why is capital allocation important?

In Anglo-Saxon corporate culture, maximizing shareholder value is the goal, and the management can only achieve this through efficient use of capital. This is why Warren Buffett sees capital allocation as the most important task of management.

The board and management have a duty to create shareholder value by allocating the company’s capital in the best possible way so as to increase value and maximize return on invested capital.