Capital allocation and the board: a critical role for the audit committee: ensure that the company has a robust and disciplined capital allocation process.

• Author: Whalen, Dennis T.

It's a good problem to have: Generating and holding record levels of cash--as many companies are today--creates more investment options. But in a period of weak global economic growth and low interest rates, it also means tougher decisions and greater scrutiny of the company's use of capital. Pay dividends? Repurchase stock? Make a strategic acquisition? Invest in organic growth?

With both traditional investors and activists sharpening their focus on how companies are deploying capital, and competitive pressures requiring more frequent shifts in strategy and spending priorities, the capital allocation process needs to be robust and well-oiled--and the board has a key role to play.

Half of the 1,300 audit committee members we surveyed recently said (perhaps not surprisingly) that they want to hear more about capital allocation. Indeed, with its focus on financial reporting and insights into the finance organization, the audit committee can serve as a catalyst for the board's deeper dive into capital allocation. We recommend the following areas of focus:

* How does the company's allocation of capital align with and advance its strategic priorities? Clearly the company must have access to the capital required to adopt and commit to its strategic plan for both the short and long term. During the capital allocation process, how much is the longterm strategy taken into account? To what extent are relative returns on capital considered among the various allocation opportunities? Are capital allocations linked to strategic goals and consistent with the company's risk appetite? Investors, and perhaps management, may argue for increased dividends or stock repurchases--which may make sense for any number of reasons, e.g., lack of profitable investment opportunities. Has management weighed the implications of dividends or stock repurchases on the company's ability to execute its long-term strategy?

* Does management have a robust capital allocation process, including the right leadership and talent? As Credit Suisse recommends in a recent study, a good first step in assessing a company's capital allocation process is to see how effectively management has allocated capital in the past. What is the company's return on invested capital and return on incremental invested capital across various businesses and geographies--and how does it compare with competitors? Have acquisitions created or destroyed value? Who is really making the investment decisions...