Capital allocation is where and how CEOs use excess profits. Effective capital allocation increases a firm’s efficiency and maximizes profits for shareholders.
What is capital allocation?
Generating free cash flow is important for businesses, but it can be challenging for CEOs to determine where the cash should go. Examples of common capital allocation decisions include returning it to shareholders through dividends, acquiring another business, paying debt obligations, investing in research and development, and hiring more employees.
Morningstar offers the Morningstar Capital Allocation Rating, which examines how well a company’s leadership teams use excess cash. The rating is based on three criteria: a company's balance sheet, investment decisions, and shareholder distributions. Companies can receive a score of poor, standard, or exemplary. Those that receive an exemplary score are the best at allocating excess profits.