What Is the Capital Intensity Ratio?
The capital intensity ratio (CIR) is a measurement of the financial efficiency of a company. By looking at the number of assets or capital a company needs to generate a dollar of revenue, it’s possible to learn about its business model’s overall health and stability. The capital intensity ratio is significant when looking at the financial statements of highly capital-intensive businesses.
The term “capital intensive” refers to business processes or industries that require large amounts of investment to produce a good or service and thus have a high percentage of fixed assets, such as property, plant, and equipment (PP&E). Companies in capital-intensive industries are often marked by high levels of depreciation.
Capital intensity measures the amount of spending on assets necessary to support a certain level of revenue, i.e. how much capital is needed to generate $1.00 of revenue.
Companies invest large amounts of capital in their production process to expect a higher proportion of its fixed assets to generate revenues. Such businesses that require a large amount of money are known as capital intensive businesses. An excellent example of such companies is power generation plants. These companies need to produce in large volumes to receive a higher return in terms of revenue.
If a company is described as “capital intensive,” its growth is implied to require substantial capital investments, whereas “non-capital-intensive” companies require less spending to create the same amount of revenue.
Common examples of capital assets can be found below:
- Property / Buildings
- Heavy Machinery
Companies with significant fixed asset purchases are considered more capital intensive, i.e. requiring consistently high capital expenditures (CapEx) as a percentage of revenue.
High CIR indicates that the company has to spend too much on its assets to generate revenue, while a low CIR means that the company is spending less on its assets and is generating very high revenues. Since this ratio shows accurately how assets are used in income generation, companies can go a step further to utilize their findings to adjust where necessary for them to generate more revenues.
Capital Intensity Ratio Formula
There are three different ways to calculate the capital intensity ratio. Each uses a different formula to calculate the metric:
1. Divide the total assets by sales
CIR = Total assets ÷ Sales
To calculate the capital intensity ratio, you need two different data sets from a company’s balance sheet: the value of a company’s total assets and the revenue in a given period. Simply divide the total assets by sales, which will provide you with the capital intensity ratio.
2. Divide capital expenditure by labor costs
CIR = Capital expenditure ÷ Labor costs
The second method involves using the corporation’s capital expenditure and labor costs. Divide capital expenditure, or what a company has spent on assets in a given period, by the labor costs over that same period.
3. Use the asset turnover ratio
CIR = 1 ÷ Asset turnover ratio
Finally, you can calculate the CIR using the asset turnover ratio. The asset turnover ratio is the inverse of the CIR; calculate it by dividing the total amount of sales by total assets. If you want to derive the CIR from this number, simply divide 1 by the asset turnover ratio.
A high capital intensive ratio means that the company has to spend more on assets to generate revenues, or the company has bought new assets. A low capital intensity ratio is an indication that the company is spending less on assets and is earning more revenue. Above all, the ratio depends on the type of the business and its operation; hence the interpretation might vary.
What Is A Good Capital Intensity Ratio?
As we mentioned at the beginning, the capital intensity ratio is useful in determining how companies are utilizing their assets in production. The concept of capital intensity ratio is insightful as it shows how efficient the company is operating. Managers should invest in this efficiency ratio so that they will be able to make an intelligent production decision on the assets they have.
Companies that are capital intensive are said to be victims of high operating leverage, and as a result of this, they should produce in large amounts to match the situation. Most of the companies which are capital intensive are mechanized and should be producing in large volumes for them to earn more revenue.
The beauty of capital intensity ratio is that it includes the cost for both fixed and variable assets in its computation hence a useful guide for strengthening the economies of scale. Some analysts, on the other hand, have a different opinion on the usefulness of capital intensive ratio as a good measure of efficiency as a result of inflation of revenue and asset components.
Whether or not a CIR is good or bad depends upon the industry a company is operating. Generally, a CIR of 1 or less than 1 is ideal, but again one must weigh the CIR in terms of the industry in which a company operates. For instance, a company operating in a service industry generally has a CIR of close to or below 1. In contrast, a manufacturing company would usually have a CIR of more than 1. Further, in capital-intensive industries like power plants, bridges, ports, hospitals, and hotels, the capital intensity ratio will always be more and maybe anywhere upwards of 2.
Thus, to get meaningful information from a company’s CIR, it is important that one considers the industry in which it operates and compares it with other companies operating in the same industry. Also, when comparing, it is very important to compare the CIRs of two similar levels of companies. Otherwise, we will not get any meaningful information; rather, the decision could be wrong.
Advantages of Capital Intensity Ratio
Following are the advantages of Capital Intensity Ratio:
- This ratio is easy to calculate because all the numbers that one needs for this ratio are easily available in the financial statements.
- There are more than one formulas to calculate this ratio. This thing also makes this ratio easier to calculate.
- It facilitates/helps businesses to understand and appreciate whether the assets are being utilized effectively and efficiently. Moreover, it helps management to identify the assets that are inefficient.
- Companies can also use this ratio to understand better the split between and impact of fixed and variable costs. This, in turn, allows businesses to reap more benefits from the economies of scale.
- CIR helps investors in determining risks associated with a company. In general, investors prefer to put their money in companies with lower CIR.
- It also helps to spot firms operating in a capital-intensive industry.
Disadvantages of CIR
- This ratio does not consider the impact of inflation on revenues and assets.
- This ratio also does not consider the valuation method that a company uses for assets. For instance, one company may use a historical method to value assets, while another company may use a fair value method. In such a case, it becomes difficult to compare the CIR ratio of the two companies.
- The use of modern technologies by a company may change the result of this ratio. So, if one company uses state-of-art technologies and another does not, this ratio may fail to give accurate results.
- CIR solely can not give much information on a company. To get meaningful information, one always needs to compare it with the industry average or of a CIR of any other company (or companies). Moreover, one needs to compare it with the CIR of a similar company; else, it may not be of any use.
The Impact of Capital Intensity on Earnings
Capital-intensive firms generally use a lot of financial leverage, as they can use plant and equipment as collateral. However, having both high operating leverage and financial leverage is very risky should sales fall unexpectedly.
Because capital-intensive industries have high depreciation costs, analysts that cover capital-intensive industries often add depreciation back to net income using a metric called earnings before interest, taxes, depreciation, and amortization (EBITDA). By using EBITDA, rather than net income, it is easier to compare the performance of companies in the same industry.
Capital Intensity Ratio Conclusion
- Capital intensity ratio (CIR) It is a ratio analysis tool that companies often use to show how well the business is utilizing its assets
- Capital intensity ratio is an analytical tool used to gauge the effectiveness of assets in production.
- This formula requires two variables: Total asset and total revenue(total sales)
- High capital intensity ratio indicates that the company has to spend more on assets to generate revenues or the company has bought new assets
- Low capital intensity ratio suggests that the company is spending less on assets and is earning more revenue
- High capital intensity ratios ratio depends on the type of the business and its operation
- The resulting figures vary across industries therefore only compare ratio for businesses in the same industry and with the same capital investment
- Capital intensity ratio has a multiplicative inverse relationship with asset turnover ratio.