Capital intensity ratio (CIR) is a metric that shows you how much capital is needed to generate $1 of revenue. It is a ratio analysis tool that companies often use to show how well the business is utilizing its assets.
It will show how well a company is generating revenues from its assets, and is reciprocal of the total asset turnover ratio (in math this means you can divide 1 by the number). Simply put, capital intensity is an analytical tool used to gauge the effectiveness of assets in production.
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.
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
Capital intensity ratio can be computed in two different ways. This is the most common formula companies use to compute their capital intensity ratio. It entails adding both long term and short assets of the company, and then you divide by its total revenue, which is simply the sales.
If you know the asset turnover ratio, you can calculate capital intensity using the following formula instead:
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.
Capital Intensity Ratio Example
ColadrinkCo, a world-renowned beverage company, is an example of a capital intensive business. In 2018 they had total revenue of $50,000 million and assets totalling $70,000 million.
In the same year their competitor, ColaBubbles Company, had a total asset turnover ratio of 0.4. Compare the capital intensity of both the companies and conclude which one is more efficient using this single metric.
First, let’s find the capital intensity ratio for each company.
ColadrinkCo
For this calculation, we have the two values needed for the first formula:
ColadrinkCo used $1.40 of assets to generate $1 of revenue.
ColaBubbles Company
For ColaBubbles, we only have their asset turnover ratio, so we’ll use the second formula to calculate the capital intensity ratio:
This means that ColaBubbles is using $2.50 of assets per $1 in revenue and seems to be not as efficient as ColadrinkCo who is only using $1.40 of assets per $1 of revenue.
Financial analysts who use this ratio to compare companies need to ensure the companies or businesses they are comparing are in the same industry. Also, the enterprises differ as others are capital intensive while others are not, so the comparison should also consider that.
In this example, both ColadrinkCo and ColaBubbles companies are operating in the same industry, and both are capital intensive so we can compare them and draw a conclusion.
Capital Intensity Ratio Analysis
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.
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.
Capital Intensity Ratio Calculator
You can use the capital intensity ratio calculator below to quickly calculate how companies are using their assets to generate revenue by entering the required numbers.
FAQs
1. What is a Capital Intensity Ratio?
The Capital Intensity Ratio (CIR) shows how efficiently a company is utilizing its assets. It can help to determine whether or not a company will be able to produce enough revenue with the number of assets it has.
2. How is a capital intensity ratio measured?
A capital intensity ratio is measured by dividing the total assets of a business by its total sales.
The formula for the capital intensity ratio is:
CIR = Total Assets / Sales
3. What does a low capital intensity ratio mean?
The capital intensity ratio is a business measurement that helps determine how effectively a company operates.
A low capital intensity ratio suggests that a company is utilizing its assets efficiently and making most of the profit from the revenue it generates from those assets.
4. Why is capital intensity ratio important?
The capital intensity ratio is important because it shows how many assets a company needs to generate a certain amount of revenue. If a company has relatively few assets, it will likely need a lot of revenue to cover those costs and make a profit.
In addition, the capital intensity ratio can be used to compare similar businesses. For example, if one business had a CIR of 0.5 and another had a CIR of 3, the first business would likely need more revenue than the second to make money.
5. What is considered a high capital intensity ratio?
A high capital intensity ratio means that a business has more fixed assets relative to the amount of revenue it brings in. A company with a lot of fixed assets will likely need more revenue than other businesses to cover those costs and make a profit.
An example of a high capital intensity ratio is a company that sells luxury vehicles. This type of business often has many high-cost assets relative to the amount of revenue it brings in.
