It might seem obvious, but effective allocation of capital is one of the most important activities for any business. With the uncertainty thrown up by the COVID-19 pandemic, businesses – SMEs in particular – might well be feeling the strain and extra pressure on their cashflow right now. Measures like the Coronavirus Business Interruption Loan Scheme (CBILS) have, in some cases, been ineffective in providing much needed liquidity to smaller firms who are much more likely to default on loans than their larger counterparts. As a result, back in April, the outlook for SMEs was pessimistic, with a survey predicting that many would run out of cash in as little as 12 weeks. With other factors added to the mix, Metapraxis predicted this time frame could be shorter still, giving certain businesses 6 – 8 weeks. It’s not only a concern for SMEs. With the worst of the economic recession still to come, good allocation of capital and effective management of cashflow is important now more than ever, for all businesses.
Optimisation strategies are already an area of massive intellectual focus. How businesses split their capital across different strategies, projects, products or services across various regions drives their financial results. Choosing to back the most profitable service lines in a time of financial uncertainty is clearly beneficial, but there are many challenges to getting this right and it’s not always simple. Businesses have to consider three main points: multiplicity of inputs, complexity of comparison and multiplicity of output.
The first refers to the number of assets that can be supported. The more assets there are, the more complex the challenge of coordinating capital allocation appropriately. Tied in with that, the second refers to how well a business can realistically compare one asset’s return with another’s – it is hard for the board to choose which assets to support if they are not directly comparable with each other. Finally, all of this needs to fit into the overall goal of the business, and what areas it is trying to maximise. To add to this complex process, multiplicity of output is going to change dramatically over the next decade as companies consider things like employee wellness, climate impact and social responsibility as outputs in their own right.
With multiple inputs and outputs to consider, the long-term equation is extremely complex. But, in the short-term, it is easier since businesses can be focused solely on financial return. Doing so, and doing it well, is a key part of any businesses’ recovery from financial hardship whether it’s caused by external, uncontrollable factors or not.
Many things must remain fixed in a short-term model. When recovering from such a prolonged and unexpected event such as the pandemic, there is generally not time to create a whole new product line, or explore a different service, although some businesses have of course achieved this. We are yet to feel the full force of the economic recession caused by Covid-19, and businesses must streamline processes and manage cashflow in order to make sure ensure they have the liquidity to survive. This starts with building a top down model of the business.
Weathering the storm
Businesses often underestimate the importance of building a model of the business that allows directors to see the impact on profitability of performance levels of different products, as well as how changes in supplier and customer payments affect cash flow. This ties into the bigger picture too – the ability to reach long-term goals will depend on identifying future risks and changes in the market, and being able to react quickly and with confidence.
This can only be done by analysing historical return on investment by business unit, region and product or service and applying these ratios to test future assumptions. This allows management to run different scenarios quickly, determining the best options and then test these with operational deliverability. If the management team can analyse how various future scenarios might pan out and what the impact might be on the business it can use this information to make better decisions.
This can be done for both business performance or internal structure changes as well as how various external events might affect the business. Any company that doesn’t have a model like this today is at a massive disadvantage as we approach the next two years of economic recovery. It is the finance team who must take responsibility for rectifying that.
Capital allocation has always and will always be at the heart of any business’s operations, especially in times of economic recession when managing cashflow becomes even more vital for survival. When a business already has a clear historical overview of its portfolio, how well products or services are performing and how previous scenarios have affected profitability, it can make more informed decisions when it comes to assessing the impact of an unexpected event.
The ability to adapt to fluctuations is hugely important to the board, particularly the CFO, when it comes to successful cashflow management. Agility in financial planning, good scenario modelling and prudent assumptions will allow a business to weather most storms.
Simon Bittlestone, CEO of Metapraxis, the financial analytics firm