Apple's Finance Function: Risk, Ethics, and Portfolio Strategy

Introduction and Company Overview

Apple is an integrated designer and marketer of consumer electronics. The company's products include computers, smartphones, tablets, and wearables, as well as the software that powers these devices. Apple is headquartered in California but contracts out manufacturing to third parties, typically in China. It operates physical retail stores and online stores in dozens of countries around the world. The global nature of Apple's business presents significant challenges for the finance department. In recent years, the company has been so profitable that it has accumulated massive cash holdings, which have typically been either returned to shareholders via dividends or invested in short-term securities — both of which generate substantial work for the finance function. This paper serves as an introduction to the finance function within Apple.

In most companies — and Apple is no exception — the finance department operates as its own team while simultaneously serving all other teams, as well as the company as a whole. The essential truth is that everything a company does is an economic transaction. There are either direct financial implications (i.e., money changing hands) or indirect implications (actions generate either costs or profits), and all of this must be measured. Because everything the company does carries financial implications, corporate finance touches every area of the organization.

Finance Touches Everything

At the individual, transactional level, finance is responsible for ensuring suppliers get paid, revenue is collected, and expense accounts are settled. For a company the size of Apple, these functions are vast and varied, and the finance team is responsible for the smooth execution of all of them.

Where the most serious work is done — work that many non-financial professionals may be unaware of — is at the strategic level. This includes risk management, portfolio management, and the management of financial returns. Key areas the finance team must consider are optimal capital structure, foreign exchange exposure, and internal controls. Much of the following discussion of the finance function focuses on these key subject areas.

Risk management in finance encompasses a wide range of activities. The most basic concept is that most risk, from a corporation's perspective, is financial: risk reflects what might happen to the company's valuation. Valuation is subject to many unknowns, and those unknowns carry downside potential. Risk management seeks to balance the need to grow with the need to minimize downside risk. By identifying and analyzing the uncertainty inherent in business activities, and attaching numbers to potential outcomes related to those uncertainties, the risk management team at Apple is able to advise senior management about the potential consequences of different courses of action (Investopedia, 2018).

Risk Management

In a smaller company, risk is often associated with theft and fraud, so risk management may focus on things like signing authority for spending and inventory tracking. For a larger international company like Apple, foreign exchange rates and other forms of macroeconomic risk become critical. Macroeconomic risk refers to risk associated with interest rates or other major changes in economic conditions that may have a direct financial impact on the company. Interest rate risk, for example, is heightened when a company has issued bonds or carries other obligations at a fixed rate.

Foreign exchange rate risk can be a substantial source of exposure for international companies. Apple's products are assembled in China from components manufactured there or elsewhere in Asia. Apple may pay in USD for finished goods from its suppliers, but what suppliers charge will relate at least in part to local market conditions. Furthermore, when Apple sells overseas it collects foreign currency, which must be converted back to USD for financial reporting purposes. This is known as translation risk. For example, if Apple sells a computer in the UK for £1,500, and that sum is worth $2,000 today, what happens when the exchange rate shifts? If that £1,500 is only worth $1,800 the next day, Apple has effectively taken a 10% reduction in its UK revenues — solely because of a change in the exchange rate. Even if Apple left those pounds in the UK, the company still faces risk associated with translating that figure back to USD for reporting purposes.

There are also transaction risks. If Apple sells a computer in Cape Town for an amount of rand equivalent to $2,000, and the company does not trust the stability of the South African rand, it may choose to repatriate as much revenue as possible to the United States. In doing so, the company takes on transaction risk — the value of the transaction can vary significantly between the time of the sale and the time the money is converted and transferred out of the country.

Apple carries a large amount of cash on its balance sheet as a result of its sustained profitability. Some of this money is returned to shareholders in the form of dividends. The decision of whether to pay dividends or to reinvest is one the finance team must advise senior management on. The finance team evaluates available projects and compares their potential returns against the returns that could be generated by simply returning that money to shareholders. There are capital structure implications to this decision, and it is the finance department's job to outline those trade-offs clearly.

Money that Apple retains may be earmarked for future growth, but until actual growth opportunities arise, those funds need to be invested so the company can earn a return. A critical role of the finance department is therefore to ensure Apple's surplus profits are invested in a way that maximizes shareholder value. There came a point when Apple held so much in cash and marketable securities that shareholders demanded the company begin paying dividends, on the grounds that Apple was clearly unable to redeploy that capital at rates that would maximize their returns. The finance department was then tasked with ensuring sufficient free cash flow was available for what were sometimes substantial dividend payments, and with advising management on appropriate dividend levels.

An important element of risk management is the finance team's ability to quantify the risks that exist. Many risks are operational or legal in nature, and it is important for senior management to understand their financial implications. Analyzing and quantifying risk is the first part of this role; the other is offering options for mitigating that risk. If management decides to increase wages and cut hours for workers at a supplier, for instance, Finance must quantify not just the direct costs but also the implications for pricing and overall competitiveness. Much of this work involves vague information, multiple moving variables, and uncertain relationships, making it extraordinarily complex — yet it is essential for a company that operates worldwide and generates tens of billions of dollars annually.

One of the key elements of modern portfolio theory (MPT) is that risk can be mitigated through diversification. The finance department advises and executes risk mitigation in several ways consistent with this principle. The influence of MPT is most visible in how Apple manages its surplus capital. A central idea in MPT is the efficient frontier — the region where the optimal balance between risk and return is achieved. Investments can lie anywhere along the efficient frontier, where all eliminable risk has been removed, and a direct relationship between risk and return is maintained along that frontier. Apple invests in both short-term and medium-term debt securities. Short-term securities are low-risk and highly liquid, suitable for funding acquisitions and dividend payments. Non-current debt securities seek higher risk — and therefore higher return — while keeping the company's overall portfolio along the efficient frontier (Investopedia, 2018).

Conclusion

Corporate finance at Apple performs a number of different functions, many pertaining specifically to risk management. An international company will face sometimes substantial risks, and as such relies on the finance department to identify and quantify those risks, communicate an assessment to senior management, and advise on mitigation strategies. At Apple, there are unique challenges related to managing financial flows within the supply chain and managing a large investment portfolio — something most companies do not have — while maintaining financial flexibility and optimizing the company's cost of capital. Maximizing returns to shareholders is a significant challenge that, for Apple, is both straightforward (from operations) and difficult (extracting value from tens of billions of dollars in cash in a low interest rate environment).