Capital Intensity Ratio: When Less is More
In a company, the capital intensity ratio is the measure the necessary capital per revenue dollar. It reveals how much assets your business needs to generate a dollar in sales, as you can see in this article. It is important to know the capital intensity ratio since it helps show how much a company’s dollar return on investment is.
For potential investors, financial ratios such as this one can be excellent measures of where to put your money. In light of particular financial climates and industries, you need to know how to read ratios such as this one effectively. You might even want to get started by taking this economics course just to get your feet wet.
Capital Intensity Ratio Formula
You can calculate the capital intensity ratio by dividing a company’s total assets by its sales or taking its reciprocal of total assets turnover ratio, as you can see in the formulas below. For this type of ratio, smaller figures are better. The lower the ratio, the less capital you need to operate your business:
- Capital Intensity Ratio = Total Assets/ Sales
- Capital Intensity Ratio = 1/ Total Assets Turnover Ratio
For a company, higher capital intensity mean that it needs more assets than those with lower ratios to generate sales in equal amounts. Higher capital intensity ratios may be due to a company’s lower use of assets. It could also be due to having a more capital-intensive business which is less intensive in terms of labor, such as if a company uses machines.
For companies in similar industries that follow similar production processes and business models, the ones with less capital intensity are better as these use less assets to generate more revenue.
When dealing with ratios of capital intensity, one caveat is that many times, the circumstances of a company dictate their ratio. For example, companies just starting out will tend to be very capital intensive since great revenue has not been amassed by the business as of yet. Also, you should not compare businesses in different industries since it is likely that to some extent, the industries dictate how capital intensive they are.
When a Company is Capital Intensive
Like we mentioned earlier, a company is said to be capital intensive when it has a high capital intensity ratio. This means that the company has to invest in significant assets to the sales revenue amounts that the assets can produce. When this is the case, the company will probably have high liability related to loans for the large number of assets. It will also have higher costs of depreciation due to the number of assets which you can learn more about with this economics course.
Industries that are capital intensive use large portions of capital for buying expensive machinery compared to their costs of labor. This term originated in the mid-19th century as factories like iron and steel began springing up in the new industrialized world. With machinery adding to the costs of capital, there were greater risks. Examples of capital intensive industries include electrical power plants, chemical plants, mining, telecommunications, oil refining and production, airlines and railways.
Capital Intensity Ratio Example 1
One example is that let’s say a company has amassed revenue that totals $200, 000 in one year’s time. In that same time period, the total assets values possessed by the company equal $500, 000. When you follow the formula:
Capital Intensity Ratio= $500, 000/ $200, 000 the answer is a ratio of 2.5
What this means is that for every single dollar this company earns in revenue, it needs to spend about $2.50. As much as possible, companies could lower this ratio. Companies that continue to heavily invest in their assets without returning revenue in the same neighborhood as the spent amounts may struggle to stay in business eventually. A company with a high ratio is called ‘capital intensive’ and will need to strike a better balance eventually, just as this economics course shows you.
Capital Intensity Ratio Example 2
In the financial year 2011-2012, Coca Cola Company earned $46, 542 million. At the end of the period, the total assets were $79, 974 million. The total turnover ratio of PepsiCo for this same period was 0.94. How do you compare both company’s capital intensity ratio and conclude which one is more efficient?
PepsiCo’s Capital Intensity Ratio:
Coca Cola’s Capital Intensity Ratio:
Total Assets/ Sales
=79, 974/ 46, 542
These ratios mean that Coca Cola needs to use $1.72 assets to generate $1 of revenue and PepsiCo needs only $1.06 dollars per $1 of revenue. This means that PepsiCo seems to be using its assets with more economical efficiency as you will see with this course on economics.
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