Today’s CFOs face big decisions when putting cash to use, and this is when FP&A professionals can be valuable partners to senior management.
Deloitte’s second quarter 2015 CFO Signals™ survey revealed that finance chiefs have a bias toward investing cash. For example, the survey showed that 84 percent of CFOs of companies that are over $1 billion in revenue are more focused on investing cash than returning it to shareholders. According to Deloitte, about 60 percent of respondents expect year-over-year gains of 5.4 percent in capital spending, a slight gain from the first quarter. That’s good news.
According to an AFP Guide to Making Capital Allocation Decisions, U.S. organizations are sitting on trillions of dollars in unused cash. How they choose to invest that idle capital will have a big impact on economic growth in general and their performance specifically. CFOs face multiple alternatives in terms of how to put cash to use. These decisions today are made ever more complex by market volatility and historically low interest rates. That’s where FP&A comes in.
Broadly, companies can invest internally (in growth or maintenance projects), they can acquire other companies or they return capital to shareholders. As FP&A professionals’ role evolves into strategic partners to senior management, they are often the ones making, reviewing and recommending business case scenarios for potential investments.
“What we see work best, is that [the group that makes those recommendations] resides in FP&A,” said Jason Logman, principal, EPM Transformation Practice, The Hackett Group. “There’s a capital group that gets involved in each project above a certain dollar and materiality threshold. They’re typically responsible for managing that portfolio.”
How to deploy cash?
How to deploy cash has long been an issue faced by organizations, according to the Deloitte report, both in times of economic strength and weakness. Those choices have an ultimate impact on shareholders’ value well into the future. However, companies often lack a framework for choosing between the alternatives. “When cash sits on the balance sheet, it isn’t being deployed on capital investment for growth, geographic expansion, efficiency, talent or research and development,” the report explained. “In short, cash on the balance sheet isn’t furthering innovation or growth. And that is the biggest uncalculated risk for many companies: the risk of failing to innovate and failing to lay the foundation for profitable future growth.”
AFP’s research shows that the starting point for many companies is the weighted average cost of capital (WACC). While treasurers are often the ones charged with calculating WACC, FP&A is the number one “consumer” of this often closely guarded number. It may be easy to assume that finance theory has already homogenized WACC calculations, and it’s true that most companies follow finance 101 theory by looking at their cost of debt and cost of equity based on their capital structure. But the AFP 2013 Cost of Capital Survey found that there remains divergence in practice, particularly in the wake of the financial crisis and the resulting environment of low interest rates and market volatility—the two key inputs into the capital asset pricing model (CAPM).
In addition, many companies do not rely solely on their WACC as the discount factor for calculating the net present value (NPV) of future cash flows of potential investments. For political, human nature, practicality and simplicity factors, many organizations tack on a “hurdle rate” on top of WACC when looking at investment opportunities. While WACC has basis in finance theory, hurdle rates are mostly arbitrary. In some cases, they’re adjusted based on the business unit, location or other risk factors. In many cases they’re not. What they do is basically mask the inherent distrust top management has in the cash flow projections submitted by managers in their investment business case.
Hurdle rates are a practical solution to a much deeper problem, which should be the focus of FP&A efforts going forward and the subject of ongoing conversations with treasurer peers, business unit managers and senior management. The key to making the right decisions is not an arbitrary hurdle rate but a more structured “gating” of “framing” process that delves deeper into the intricacies of the cash flow forecasting assumptions embedded in investment business cases. To get this right, companies are better off polishing their WACC and applying it consistently across investments, while spending extra time on ensuring that managers submit realistic and risk-adjusted cash flow forecasts.