What is Capital Intensive
Capital intensive refers to business processes or industries that require large amounts of investment to produce a good or service, and therefore have a high percentage of fixed assets, which are also known as property, plant, and equipment (PP&E). Companies in capital-intensive industries are often marked by high levels of depreciation.
BREAKING DOWN Capital Intensive
Capital intensive industries tend to have high levels of operating leverage, which is the ratio of fixed costs to variable costs. As a result, capital intensive industries need a high volume of production to provide an adequate return on investment. This also means that small changes in sales can lead to big changes in profits and return on invested capital.
Their high operating leverage makes capital intensive industries much more vulnerable to economic slowdowns compared to labor-intensive businesses because they still have to pay the fixed costs such as overhead on the plants that house the equipment, depreciation on the equipment and other fixed costs associated with a capital intensive businesses, even when the industry is in recession.
Examples of capital-intensive industries include automobile manufacturing, oil production and refining, steel production, telecommunications and transportation sectors, like railways and airlines. All these industries require massive amounts of capital expenditure. For more on investing in capital-intensive industries, read Capital Intensive Companies: What Are The Pros & Cons for Investors?
Measuring Capital Intensity
Besides operating leverage, the capital intensity of a company can be gauged by calculating how many assets are needed to produce a dollar of sales, which is total assets divided by sales. This is the inverse of the asset turnover ratio, an indicator of the efficiency with which a company is deploying its assets in generating revenue.
Another way to measure a firm's capital intensity is to compare capital expenses to labor expenses. For example, if a company spends $100,000 on capital expenditures and $30,000 on labor, it means the company is most likely capital-intensive. Likewise, if a company spends $300,000 on labor and only $10,000 on capital expenditures, it means the company is more service- or labor-oriented.
The Impact of Capital Intensity on Earnings
Capital-intensive firms generally use lots 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.
But 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, a non-cash expense, instead of net income in performance ratios, it is easier to compare the performance of companies in the same industry.