Introduction
Fixed assets, often referred to as property, plant and equipment, are an essential part of any business, especially businesses in the manufacturing industry. They use fixed assets in their operations to generate wealth in the long-term. Fixed assets are also defined as assets that business use for more than a single accounting period and are not for sale in ordinary conditions. Examples of fixed assets include building which businesses use for operations, vehicles used to transport goods, machines used for production, etc. Fixed assets are different from inventory or stock, which are the assets that businesses sell to generate revenue and are short-term.
Different businesses will have their own unique fixed asset structures. For example, some of these structures may not require a lot of assets to complete their operations. This applies to businesses in the services industry, where a high amount of fixed assets is not necessary for operations. On the other hand, some other businesses may only rely on fixed assets to generate income. For instance, a freight company will mainly depend on different vehicles to complete their operations. In the absence of fixed assets, these businesses cannot operate.
Businesses that rely on a high amount of fixed assets or investments are known as capital intensive businesses. The capital intensity of a business can be determined using the capital intensity ratio of a business. The ratio can be very beneficial for businesses and investors. Therefore, it is vital to understand what is capital intensity ratio.
What is Capital Intensity Ratio?
Capital intensity ratio is a measure of the total amount of capital assets needed to generate revenue. In simpler terms, it is the measure of how much assets a business uses to generate $1 in revenues. It is a ratio that a business can use to demonstrate how efficiently it is utilizing its assets in the generation of revenues.
What are Capital Intensive Businesses?
Capital intensive businesses are those businesses that heavily rely on assets to generate revenues. Examples of businesses operating in a capital intensive industry include large manufacturing companies, oil refining or exploration companies, electrical power generation companies, etc. These are all industries or businesses that require a large amount of upfront investment to get started. If these businesses do not meet the asset requirements, they cannot operate at all or at least not efficiently. Apart from industries or specific businesses, particular business processes can also be termed as capital-intensive for example, the production process.
When economists describe a production process as capital-intensive, they mean that the production process within a business needs a large amount of investment or capital assets. For example, Samsung’s production processes can be described as capital-intensive because it requires a lot of machinery and other assets to operate.
In contrast, services-based businesses are the opposite of capital intensive businesses. These are also known as labour-intensive businesses. These businesses require a small amount of investment upfront and can even operate in the absence of capital assets. For example, a law firm can operate with very minimal investment but still operate efficiently and effectively.
Purpose of Calculating Capital Intensity Ratio
The main purpose of calculating the capital intensity ratio of a business is to determine its efficiency in utilizing its assets to generate revenues. The lower the capital intensity ratio of business is, the better it is considered. This is because a lower ratio means that the business is efficiently utilizing its assets to generate revenue. Two factors cause a lower capital intensity ratio, either a low amount of assets or capital invested in a business or high revenue generated by the business.
The ratio can also be used by investors to determine the risks of their investment in a business. Usually, businesses with a high capital intensity ratio are riskier investments because they require a higher amount of investment for lower returns. In contrast, businesses that require lower investments to generate more revenues are preferred by investors.
How to Calculate Capital Intensity Ratio?
The capital intensity ratio of a business can be calculated using the capital intensity ratio formula. The formula can is as below:
Capital Intensity Ratio = Total Assets / Net Revenues
The figure for total assets of a business is available in its Statement of Financial Position. It will contain both non-current or fixed assets of a business, and current assets of the business. The Net Revenues of a business consists of its sales for a specific period. It is available in the Statement of Profit or Loss of the business.
The capital intensity ratio of a business can also be calculated by taking a reciprocal of the total asset turnover which is one of the capital budgeting tools of the business. Therefore, the formula becomes:
Capital Intensity Ratio = 1 / Total Asset Turnover
Finally, the capital intensity ratio can also be calculated to determine the amount of capital required, instead of labour, to generate revenues. In that case, the capital intensity ratio formula becomes:
Capital Intensity Ratio = Capital Expenditure / Labor Costs
The above formula is not as commonly used by investors or businesses, since the information is more difficult to obtain. The first formula is widely used because the information necessary to calculate it is readily available.
Relationship between Capital Intensity Ratio and Total Asset Turnover
The relationship between capital intensity ratio and total asset turnover ratio is already clarified using the above formula. The capital intensity ratio is known as the reciprocal of the total asset turnover ratio. This basically creates a relationship between total asset turnover and capital intensity ratio. Furthermore, it means that when calculating either of the two ratios, if the other ratio is already available, the first ratio can be calculated easily.
The reciprocal relationship between capital intensity ratio and total asset turnover can be clarified even further by looking at their formulas. As discussed above the capital intensity ratio formula is:
Capital Intensity Ratio = Total Assets / Net Revenues
On the other hand, the total asset turnover formula is:
Total Asset Turnover = Net Revenues / Total Assets
While the capital intensity ratio of business signifies how much assets it has used to generate $1 in revenue, the total asset turnover shows how much revenues the business has generated for every $1 in assets. This relationship between them is called a reciprocal relationship.
How to Use Capital Intensity Ratio?
Using or interpreting the capital intensity ratio is straightforward. If the capital intensity ratio of a business is high, then the business is said to have used more assets in producing revenue. In comparison, when the capital intensity ratio of business is low, then it is said to have used fewer assets in generating its revenues. Using lesser assets to generate revenue generally means that the business was able to utilize its resources efficiently.
Overall, businesses and investors prefer low capital intensity ratios over high ratios. However, a high capital intensity ratio does not necessarily mean the business is inefficient. To properly interpret the capital intensity ratio of a business, it must be compared with ratios of other businesses. As mentioned above, service-based or labour intensive businesses will have a lower capital intensity ratio as compared to a production-based or capital intensive business.
Therefore, it is important that to interpret the capital intensity ratio properly, it must be compared with the ratios of similar businesses. Similar businesses include competitors or other businesses within the same industry. Similarly, for an even better interpretation of the capital intensity ratio of a business, it is necessary to calculate the average capital intensity ratio of the industry the business is operating in and compare them. Only then can the ratio be easily interpreted and decisions based on the interpretation will be meaningful.
Example and Analysis
A company, ABC Co., has total assets of $100 million while it generated revenues equal to $80 million in a single period. Therefore, the capital intensity ratio of ABC Co. can be calculated using the following capital intensity formula:
Capital Intensity Ratio = Total Assets / Net Revenues
Capital Intensity Ratio = $100 million / $80 million
Hence, Capital Intensity Ratio = 1.25
This means that for every $1 revenue that ABC Co. has generated, it has used 1.25 times assets. However, as mentioned above, this ratio is not meaningful unless it can be compared with ratios of other business or the industry as a whole.
Another company, XYZ Co., within the same industry, has total assets of $200 million while it generated revenues of $150 million. The capital intensity of the company can be calculated as follows:
Capital Intensity Ratio = Total Assets / Net Revenues
Capital Intensity Ratio = $200 million / $150 million
Hence, Capital Intensity Ratio = 1.33
The capital intensity ratio of XYZ Co. is higher than that of ABC Co. This means that XYZ Co. has used more assets to generate lesser revenue. Although both the assets and revenues of XYZ Co. are significantly higher than that of ABC Co., ABC Co. has been able to utilize its resources more efficiently than XYZ Co.
While this comparison is just for two companies, it may be more meaningful to compare the performance of both companies against the industrial average to get a more meaningful comparison. This is mainly because while the comparison does help identify which company did better, it still does not paint a clear picture of whether both the companies did better or worse as compare to the industry as a whole.
What is a Good Capital Intensity Ratio?
While calculating the capital intensity ratio of businesses, it may be necessary to know what is a good capital intensity ratio. A good capital intensity ratio is dictated by the industry a business is operating in. While, generally, a capital intensity ratio below 1 or at least close to it should be ideal, it may not be possible in every industry. For example, service-based industries will usually have capital intensity ratios close to or below 1. On the other hand, manufacturing industries may find it difficult to achieve the same ratio.
Therefore, to determine what a good capital intensity ratio is, it is necessary to use it comparatively rather than on its own. When using it comparatively, it must also be compared with businesses that are similar to each other rather than completely different businesses. This point was also demonstrated in the example above.
Advantages of Capital Intensity Ratio
There are many advantages to the capital intensity ratio. First of all, the capital intensity ratio is very easy to calculate. This is because the information needed to calculate it is readily available in the financial statements of a business. Similarly, different formulas can be used to calculate the capital intensity ratio of a business, thus, allowing for easier calculations.
Businesses can use the capital intensity ratio to determine whether they are using their assets to their maximum efficiency. Based on the ratio, businesses can identify any processes or areas within the business that are inefficient.
The capital intensity ratio can also be used by businesses to get a better insight regarding the spread over fixed and variable costs. Through this, these businesses can strengthen their economies of scale, which can result in better profits for them.
The capital intensive ratio can also be used by investors to determine the risks associated with investing in a particular business. As mentioned above, investors generally prefer to invest in businesses that have a lower capital intensity as opposed to higher capital intensity.
Disadvantages of Capital Intensity Ratio
The capital intensity ratio may also have some disadvantages. First of all, it does not take into consideration the valuation basis used for assets. For example, one business may use a historical method of valuing assets while another business may use a fair value method for valuing assets, thus, creating inconsistent results. Similarly, it does not consider the effect of inflation on revenues and assets.
Furthermore, the capital intensity ratio cannot be used on its own. It always needs to be used comparatively to produce meaningful results. Even when used comparatively, it must be used to compare between similar businesses or else it will result in wrong decisions.
Conclusion
Capital intensity ratio is the ratio of total assets of a business to its net revenues. It signifies the utilization of assets of a business in generating its revenues. It can also be used to identify businesses operating in a capital intensive industry. The ratio is closely related to total asset turnover as both are reciprocals of each other. The capital intensity ratio must be used comparatively rather than on its own to produce meaningful results. Usually, the lower the capital intensity ratio of business is, the better it is considered. However, whether a capital intensity ratio is good or bad depends on the industry of the business being evaluated.
