How to identify a company's capital allocation strategy

Capital allocation is the act of deciding what to do with cash generated from operations or raised from equity or debt markets. It is often referred to as a CEO’s most important job, and they generally have five main options.

The five main avenues for capital

Pay dividends

Dividends are perhaps the purest form of capital return. The company decides a percentage of profits to pay out and each shareholder gets a cash payment for each share they own. The shareholder can then decide to spend, save or reinvest the funds they receive.

Buy back shares

By buying back shares the company increases the percentage ownership of the remaining shareholders. Just like any share purchase, price matters. If shares are repurchased at a price above their intrinsic value, it is likely the money could have achieved a better return elsewhere.

Pay down debt

Paying off debt is also a return of capital – only this time to bondholders rather than shareholders. This can also be a good thing for shareholders as lowering debt can reduce the financial risk of a company. It should also reduce future interest and debt payments, meaning more cash can be allocated elsewhere.

Invest in organic growth

Profits can be reinvested in the hope of sowing even more profits in the future. Investments in organic growth might include buying more property and equipment, increasing research and development spending, hiring more staff or moving into new territories or product lines.

Buy other companies

Instead of reinvesting internally, management might choose to acquire another company. Creating shareholder value through acquisitions is famously hard – but it is possible. Berkshire Hathaway (NYS:BRK.A), Constellation Software (TSE:CSU) and Danaher (NYS:DHR) have excelled while channeling a lot of capital towards acquisitions. But the fact they are so famous might tell you something.

Unless investments in growth can return more than the company’s cost of capital, profits should likely be put towards dividends, debt reduction and share buybacks at favourable prices. The right decision for a company is closely linked to the maturity of its business and the industry it operates in. If a company still has plenty of room to grow its sales and profits, a higher reinvestment rate is probably more suitable.

How to spot capital allocation decisions in the financial statements

This article will show you how to assess capital allocation decisions in a company’s numbers. To do this, we will study ResMed’s income statement, cash flow statement and balance sheet from their 2016-2023 annual reports.

ResMed (ASX:RMD) is a medical device and software company focused on treating sleep apnea. They are one of two leading players in the market and recorded over USD $4 billion of revenue in 2023. Because ResMed’s primary market listing is in New York, the numbers in this article are all in US dollars.

First, we’re going to look at how much of ResMed’s profits have been dedicated to returning capital versus growth investments. To do that, we’re going to look at dividends and share buybacks.

ResMed's dividend payout ratio

To find out what percentage of ResMed’s 2023 profits were paid out as dividends, I took the “Cash Dividends Paid” from the financing section of their Cash Flow Statement. I then divided this number by “Net Income” figure at the top of this document. You can see both of these numbers highlighted in the cash flow statement below. 

ResMed earned $0.9 billion in profit in 2023 and paid out around USD 0.25 billion of it in dividends.

This gives us a dividend payout ratio of 29%, which is relatively low compared to other large-cap ASX stocks and other healthcare firms:

A lower dividend payout ratio can mean that management sees opportunities to invest profitably in future growth. By contrast, more mature companies in low growth industries usually pay out most of their profits as dividends.

Like most financial measures, dividend payout ratios are more useful when you look at them over a longer period. Doing so shows us that ResMed’s dividend payout ratio has trended down from over 50% to around 30%.

Even at this early stage, we’ve learned two valuable things about ResMed’s capital allocation:

• It has a relatively low dividend payout ratio
  
  
• It has recently pivoted to paying a lower percentage of profits out as dividends

I then looked at share buybacks to see if ResMed’s profits have been funneled here instead.

ResMed's share buybacks

Share buybacks show up in the investing activities section of the Cash Flow statement under the line item “Payments for common stock”. At the time of their 2023 annual report, ResMed had not spent any money on share repurchases since 2019 so there is no line entry for this in the 2023 report. 

The Cash Flow Statement does show us the money generated by issuing new shares. For ResMed, this has been larger – a total of over $300m since 2016. You might want to understand why this has happened, but it is beyond our remit today. One thing is clear though – ResMed has not used its profits to aggressively reduce the share count recently.

Let’s look at our running total:

• ResMed has a relatively low dividend payout ratio
  
  
• ResMed pivoted to paying out less profits
  
  
• ResMed is not buying back shares at the moment

This suggests that most of ResMed’s profits are being reinvested in the hope of generating future profits.

Different types of growth investment

As we covered earlier, growth investments can be organic (internal) or inorganic (buying other companies). Investments in organic growth might include:

• Higher research and development (R&D) spend
  
  
• Hiring more staff
  
  
• Buying more Plant, Property and Equipment (usually called Capital Expenditures or capex)

For investments in R&D and capex, it can be useful to take these amounts as a percentage of a company’s revenue over time. To do this, I found the amount spent on R&D near the top of ResMed’s Income Statement:

And I found their outlay on capex in the “Cash flow from investing activities” part of the Cash Flow Statement:

Taking a longer view, we can see that both R&D and Capex have stayed at similar levels as a percentage of revenue:

Staff are another potential investment area, so I looked at the number of full-time employees reported in ResMed’s annual reports:

ResMed’s headcount has essentially doubled since 2018. But this hasn’t happened in a straight line. There are several years of small growth and a few big bumps in 2016, 2017, 2019 and 2023. This offers a clue as to how ResMed has invested in future growth.

ResMed’s acquisition strategy

By looking at the investing activities section of ResMed’s cash flow statement since 2016, we can see they have spent over $3 billion buying other businesses. The company’s net income totaled just under $4.2 billion over this period, so it is a significant amount.

As we suspected from the changes in headcount, ResMed’s biggest dealmaking years were in 2016, 2019, and 2023. Here is how Morningstar analyst Shane Ponraj describes ResMed’s acquisition strategy:

“ResMed has made acquisitions of home healthcare software platforms as it seeks to leverage the trends of digital health and providing care in a lower-cost setting. Brightree, acquired in 2016, and MatrixCare, acquired in 2019, offer business management software for a range of home health providers. ResMed is currently directing significant capital to this area, and although high returns have largely been unproven, we think the move has been strategically sound given the structural industry tailwinds.

ResMed also has a minority stake in Nyxoah who are developing a neurostimulation implant to treat OSA. Although we see little near-term risk from this therapy due to the higher cost and invasive surgery needed, ResMed’s minority stake hedges some risk from emerging competition.”

As Shane alluded to, it can be hard to judge the merit of an acquisition until many years later. But we can be clear on this: ResMed has allocated a lot of capital to acquisitions over the past few years.

Another important use of capital

You might remember that paying off debt is another common way to spend excess profits. You can see repayments of debt in the financing section of a company’s cash flow statement:

The effects of this will also show up in the balance sheet, which shows what a company owns (assets) and owes (liabilities). Major things to note in the balance sheet include:

• Total borrowings (the sum of current and long-term debt)
  
  
• Cash and equivalents (from the balance sheet)
  
  
• Net debt (borrowings minus cash)

Here is that data for ResMed from 2016-2023:

I have highlighted ResMed’s big dealmaking years in yellow because I think there is clear trend. Whenever ResMed has borrowed money to do a deal, it has aggressively channeled earnings towards debt repayments in the years after.

Total borrowings fell from almost $1.2bn in 2016 to $0.3bn in 2018. Then they fell again from almost $1.3bn in 2019 to under $0.7bn in 2021. This shows how knowledge of real-world events adds context to the numbers you see bouncing around in financial statements.

What we’ve learned about ResMed

ResMed’s financial statements have taught us a lot about their capital allocation in recent years. We learned that:

• ResMed has cut the percentage of profits distributed as dividends
  
  
• ResMed did not buy back a lot of its own shares
  
  
• ResMed’s investments in R&D and Capex stayed constant
  
  
• ResMed allocated most capital to acquisitions and paying off debt

One thing we haven’t done is assess how wise these capital allocation decisions were.

That is a topic for another day – but in case you were curious, our analyst Shane Ponraj rated ResMed’s capital allocation as “Exemplary” as of May 2024. He cited a strong balance sheet, efficient investments and appropriate shareholder distributions.

If you'd like to learn more about assessing capital allocation, take a look at Shani's article 'The most important decision a CEO can make'.

And for more on ResMed, you can view its security detail page here and read about their impressive Q3 fiscal 2024 earnings here.