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Optimal Capital Allocation Strategies: CFOs Pondering Business Systems Agility and Resilience
What are the functions of CFOs? How do firms determine the optimal capital allocation strategy- best mix of debt, equity, and internal financing that maximizes the return on invested capital? How do firms choose their capital structure? How do firms align and integrate their business systems and processes to facilitate learning, coordination, collaboration, and innovation? These strategic questions relate to business systems agility and resilience in disruptive, emergent and dynamic circumstances; and the optimal capital allocation strategies and capital structure of a business enterprise-the appropriate mix of debt and equity that maximizes the return on investment and shareholders’ wealth while minimizing the weighted average cost of capital (WACC), simultaneously.
While disruptions often reveal the potential vulnerabilities of business systems, processes, and procedures, they also provide insights into business agility- capacity for rapid change and for flexibility in operations and resilience- ability to anticipate, recover from disruptions, emergencies, withstand or recover quickly from difficult and adverse conditions. Clearly, effective capital allocation strategy is vital to a sound business strategy designed to maximize the wealth producing capacity of the enterprise. In these series on optimal capital allocation strategies, we will focus on business systems and processes agility and resilience and provide some practical guidance. The overriding purpose of this article is to highlight some key portfolio of CFOs as we ponder industry best practices in business systems agility and resilience. For specific financial management strategies please consult a competent professional.
Some Duties of CFOs
CFOs are responsible for firms’ past and present financial health and constitute an integral part of a firm’s senior leadership in charge of financial management-acquisition and allocation of financial resources. CFOs have multiple duties, that include reviewing and presenting financial statements, planning budgets-cash and capital; and deciding where and when to invest firm’s funds. CFOs design, plan and execute the capital structure of the firm-determine the best mix of debt, equity, and internal financing. Addressing the issues surrounding optimal capital structure and allocation is one of the most important duties of CFOs.
Some Practical Guidance
As I have already explained, while disruptions often reveal the potential vulnerabilities of business systems, processes, and procedures, they also provide insights into business systems agility and resilience. The COVID-19 pandemic was not an exception, it tested the effectiveness of firms’ capital allocation strategies, planning and execution. Firms that were able to quickly re-prioritize investments and re-allocate capital have weathered the storm and, in some cases, even improved their competitive position. But a slight majority of CFOs indicate the COVID-19 pandemic had an overall negative effect on their firm’s ability to efficiently and effectively invest capital in 2020. The apparent lack of agility and resilience in so many firms call for culture of assessment and opportunities for continuous improvement.
Most CFOs indicate the pandemic has forced them to completely rethink their capital allocation strategy, business financial systems, processes, and procedures. There is gathering empirical evidence suggesting that many firms have embraced remote work based on veritable data on productivity. For example, health care providers have fully embraced telemedicine. Many manufacturers have established new health and safety procedures. The question every firm must now answer is which of the many business model changes are strategic and which are only transactional? Additionally, the COVID-19 pandemic has accelerated some trends that were already in place, such as the push into all things digital. In fact, digital technology, which supports trends such as telemedicine and remote working, is the area were CFOs most frequently indicate investment increased in 2020 vs. 2019.
A significant majority of CFOs indicate accelerated digital transformation will impact capital allocation going forward. With so much uncertainty, firms need to weigh the likelihood of various scenarios to determine what their business may look like in the future, and then align their strategy and capital allocation accordingly. CFOs must carefully determine what assets and capabilities they have and need. Once the future state of the firm is carefully assessed, then CFOs must take inventory of the businesses and assets in their portfolio. Systematic periodic portfolio reviews can help CFOs find assets that no longer align with firm’s long-term strategy but can easily be divested to fund future investments.
There is gathering empirical evidence suggesting that the COVD-19 pandemic has forced closer examination of corporate financial portfolios. Indeed, significant majority of CFOs indicate they plan sustained review and rebalancing of their portfolios to focus on the core businesses. Firms should continuously evaluate which assets and capabilities within their portfolio will help enable their future-state business model. Should these assets and capabilities be owned because they are at the very core of the business? Could they instead be acquired through partnerships or purchased from third parties, with the trade-off of giving up some control? Many companies are considering these “asset-light” business models that look to source non-core capabilities or inputs into the business through strategic alliances, partnerships, joint ventures, collaborations, or outsourcing agreements.
The goal of evaluating whether your firm is the best owner of each asset is to free up capital to invest in the capabilities that will be core to the business enterprise in the future. Funding future portfolios requires a capital allocation process with governance that instills discipline and enables unbiased decision-making. The process must also be agile enough to adapt to changing business needs. But many CFOs indicate their capital allocation approach is not adequately flexible and regularly updated nor informed with necessary data. Therefore, the business financial systems and processes should be systematic, deployed and integrated to facilitate learning, innovation, and continuous improvement.
There is material empirical evidence suggesting that even when the process is systematic, more than a simple majority of CFOs indicate their capital allocation process is not always followed. Consequently, less than half of CFOs indicate they can quickly assess market threats and opportunities and reprioritize planned investments accordingly. This can hinder long-term shareholder returns as only slightly less average number of CFOs indicate their capital allocation process is successfully helping them achieve their Total Share Return (TSR) goals-a measure of financial performance, indicating the total amount an investor reaps from an investment-specifically, equities or shares of stock. In practice, TSR factors in capital gains and dividends when measuring the total return generated by a stock. The formula for calculating TSR is (current price – purchase price) + dividends / purchase price. TSR represents an easily understood metric of the overall financial benefits generated for stockholders. Therefore, TSR is a good indicator of an investment’s long-term value, but it is limited to past performance, requires an investment to generate cash flows, and can be sensitive to stock market volatility.
Process Alignment and Integration
Extant academic literature and best industry professional practices suggest that in firms with aligned and integrated business systems and approaches, operations are characterized by repeatable processes that are routinely evaluated for continuous improvement. Learning is shared and there is deliberate coordination among all business units. Further, processes adhere to key strategies and goals and are regularly evaluated for change and continuous improvement in collaboration with various business units. The firm so aligned and integrated seeks to achieve efficiency, quality, innovation, and customer responsiveness across all functional areas of the business enterprise through analysis, innovation, and sharing of information and knowledge management designed to create and maintain competitive advantage in the global marketplace.
Processes and measures track progress in key strategic and operational goals. Aligned and integrated processes require consistency among plans, processes, information, resource decisions, workforce capability and capacity, actions, results, and analyses that support key system-wide goals and strategic priorities. Effective alignment requires a common understanding of shared purposes, critical functions, and goals. It also requires the use of complementary measures and information to drive planning, tracking, analysis, learning, innovation, and continuous improvement at all levels. Effective alignment and integration require harmonization of plans, processes, and knowledge management to support key system-wide goals. Therefore, effective integration goes beyond alignment and is achieved when the individual components of a firm’s performance management system operate as a fully interconnected unit. Functional adaptability is the measure of matured business systems and processes.
Agility and Resilience
Best industry professional practices suggest agility and resilience require business leaders to know, understand and anticipate emergent business challenges, stay flexible to adapt to shifts in the global marketplace and initiate change in their firms. It’s the dynamic business enterprises that have a much better chance to survive – and even to thrive – in the shifting global business environment. Further, agility and resilience relate to the firm’s ability to plan, anticipate, prepare for, and recover from disasters, emergencies, and other disruptions, and protect and enhance workforce and customer engagement, supply-network and financial performance, firm’s productivity, and community well-being when disruptions strike.
Additionally, resilience requires agility throughout the firm and goes beyond the ability to return to status quo ante when disruptions emerge. In practice, resilience means having a plan in place that allows the firm to continue operating as needed during disruptions. To achieve resilience, business leaders must cultivate the agility to respond quickly to both opportunities and threats, adapt strategy to changing circumstances, and have robust governance with a culture of trust. Agile and resilient firms adopt an ecosystem mindset, embrace data-rich thought processes, and equip their workforce with ongoing learning of new skills and align business systems around critical functions.
In sum, changes in customer requirements, uncertainty over the pace of the post-pandemic recovery, challenges in developing accurate forecasts, and the need to decide which changes accelerated by the COVID-19 pandemic are strategic and which are transitory all point to the importance of culture of assessment and continuous improvement in the capital allocation systems and processes. While most CFOs indicate they review their capital allocation process annually, only few perform gap analysis and regularly analyze how the process needs to be modified.
Given the speed of market dynamic, firms should be striving for a capital allocation process that is fully aligned, integrated and innovative. The capital allocation process should not end when decisions are made. During implementation, CFOs and their teams should verify that the assumptions made around the investments are proving out or require in-flight adjustments. After implementation, governance should also call for gap analysis to determine the effectiveness of the allocation strategies and then incorporate those learnings into future investment decision-making. A clear majority of CFOs indicate their process framework and governance, and project monitoring and review are only slightly or not at all effective. These challenges can hinder business financial system agility and resilience during disruptions and changing market conditions, leaving firms vulnerable and unable to pivot when needed.
Firms should utilize advanced tools to gather and analyze data. Key performance indicators (KPIs) are being evaluated on more metrics than ever before, both quantitative and qualitative. For example, sustainability metrics are now critical and go beyond revenue and profits but also address the social and environmental impacts of business strategies and decisions. Missing key industry benchmarks on any of these metrics can imperil earnings, firm’s reputation, and long-term value creation. Lack of data and analysis capability are among the most cited barriers to optimal capital allocation. All decisions must be data driven if firms are to create and maintain competitive advantage in the relevant market segments.
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