A phrase I am hearing a lot in conversation with my networks is: ‘this business model is capital light‘. It seems to most aspiring entrepreneurs this is preferable to ‘Capital heavy’, for the obvious reason that the upfront cash at start-up is less. However, while useful, it also is only one way of looking at a business model and its associated strengths and weaknesses.
Capital-intensive businesses have high fixed costs compared to variable costs, making them vulnerable to a slowdown, as they are very volume sensitive. Their breakeven point is higher than businesses less capital intensive. However, once they reach that break-even point, most of the rest is profit.
The obvious contrast is between an oil refinery or steel-making plant, to an accounting or law practice. The former needs considerable capital deployed before there is any consideration of the labour, management, and raw material required for conversion. The latter requires just offices and capable personnel.
In effect, Capital Intensity is a measure of how many dollars of capital are required to generate a dollar of sales?
Capital intensity requires that the assets be procured in order to be operational. This can be a mix of cash retained from earnings, or available from shareholders, loans, or ‘outsourcing’ manufacturing to a contractor who has, or will add, capacity for ‘rent’. An additional source is from suppliers so long as your debtor days are less than your creditor days, in which case, your creditors are in effect adding to the funding of your business.
Often you will see the term ROCE or Return On Capital Employed in financial reports. This is simply the ratio of profit to capital. If you generate $1 in profit for every dollar of capital, you will have a capital efficiency ratio of 1:1.
It is a useful macro measure of the efficiency of the capital used in the business, just as it is a valid calculation of the efficiency of a machine: Revenue/Capital cost of the machine.
Successful businesses use capital to generate revenue and profits, the more successful you are, the better you have used the capital deployed.
How much capital is required to generate your profits?
How to Calculate Capital Intensity
The capital intensity formula is:
Capital Intensity = Fixed Assets / Total Revenue
Example
Imagine a company has $100,000 in fixed assets and $1,000,000 in total revenue. The company’s capital intensity would be: $100,000 / $1,000,000 = 0.1
This means that the company needs 10 cents of capital to generate every dollar of revenue.
Increasingly, the capital required early in the life of a business is reducing as digital technology evolves, removing the capital requirement as a barrier to entry to many industry segments. This is leading to a transfer from capital intensive to ‘technology intensive’, which is in turn becoming increasingly complex and expensive as technology evolves at an accelerating rate, and the business cycles become shorter.
As the old saying goes, there is never a free lunch!
