Capital Intensive Definition
Capital intensive refers to those industries or companies that require large upfront capital investmentsCapital InvestmentsCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Capital intensive companies have a higher proportion of fixed assets than the total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more. Capital intensive industries examples include oil & gas, automobiles, manufacturing firms, real estate, metals & mining.
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Example of High Capital Intensive Industries
Imagine you are a utility provider and want to set up a plant that provides electricity to southern California. First, the company has to build coal, nuclear, or wind power stations. After which, they set up a transmission sector and then a billing and retail sector. For doing all these, the upfront costs will, in general, be billions of dollars – which are recorded as assets on the company’s balance sheet. For example, PG&E, the electric provider under strict scrutiny for recent California fires, has a total asset value of $89 billion. More than $65 billion is for different plant property and equipmentPlant Property And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. read more types. It means PG&E has spent a lot to set up its plants and uses only a fraction of it as working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more. Now, let us look at a low capital-intensive company.
Example of Low Capital Intensive Industries
Imagine you are a software provider. You create software products and sell them off for a profit. In this case, there are no direct upfront costs. You hire several engineers, and the only upfront costs will be their salaries. At the same point, look at the asset size of Facebook. The total asset value of Facebook (the plant property and equipment) is just over $100 billion. However, Facebook is worth over $400 billion. The reason is that Facebook is not a capital intensive company. Its nature lies in the asset’s delicate nature and the company’s ability to grow.
Advantages of Capital-Intensive Industries
The following are some advantages of capital intensive companies.
- Ford, the car company, stayed as the leader of US automobiles for over 50 years. There are only a few automobile manufacturers in the USA. The same is the case with airplane manufacturing. Since airplane manufacturing is one of the most capital intensive, the ability of a normal person to go out and start a company on his own is almost zero. It ensures the incumbent players are safe and out of competition for everyone. The barriers to entry are highThe Barriers To Entry Are HighBarriers to entry are the economic hurdles that a new entrant must face in order to enter a market. For example, new entrants must pay fixed costs regardless of production or sales that would not have been incurred if the participant had not been a new entrant.read more, and not everyone can get into the contest.
- The ability to have assets on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more; during the 1950s and 60s, the time was ripe for production-based companies. In addition, all these production companies require heavy capital investment. People who invested in these companies looked at the amount they invested in plant property and equipment and decided the company’s value. It is essentially called value investingValue InvestingValue investing is a long-term strategy that involves buying and holding undervalued securities, real estate, or other financial assets.read more. Because people wanted to buy sharesBuy SharesKnowing how to buy shares is crucial for a person who wants exposure to the equity market. Equity markets are volatile, and timing is very important. Shares trade in exchanges, but you just can’t go and buy a share from the exchange. There are several steps involved in purchasing a share.read more of only asset-heavy companies, the investment in such companies remained safe.
- All capital investments are tax-deductible and easily trackable. One can always price GE’s plane engines or a factory that produces a million bolts per month. This tangible nature helps people analyze the companies better and, in turn, makes investing easy. Apart from these, investing in intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more is not a capital investment and will not be tax-deductible. This extra benefit nudged people towards funding more capital-intensive works.
Disadvantages of Capital Intensive Projects
The following are some disadvantages of capital intensive projects.
- Facebook had multiple iterations before it released its first version of the world. It is because all the incremental improvements were easy – because the project was not capital intensive. The risk of loss is low in capital-intensive projects, but the quantum of possible losses is extremely high.
- If the company goes on fire sale, the losses will be high. A fire sale is when the company requires money for working capital and sells off the assets. As the company sets itself up for a fire sale, its assets lose value so fast that only 30%-35% of it will be realized.
- The company cannot pivot easily. Most companies experiment with the nature of their products. Netflix shifted from a CD-based business to a streaming service in a year. Whereas GE, an extremely capital-intensive company, took over 15 years to change its direction. Spending money on projects anchors you over in that domain and makes movement difficult.
- The competition will be strong. We argued that heavy capital companies are safe from competition because of their high barriers. However, if there is a competition, the competition will be quite strong—the example of Boeing vs. Airbus is great. Until they were the only players, they had market dominance and controlled the prices. However, when the Brazilian government helped the barrier in becoming one of the major airplane manufacturers by subsidizing them, it took a huge chunk of market share because of cheaper planes. It explains how, even though capital intensive companies are safe and the probability of competition is low, the possible losses are high once competition comes in once competition comes in.
Conclusion
Multiple reasons and decisions go into whether the company should be capital intensive. There are businesses where initial high capital is not a choice (utilities, power, automobiles), and there are businesses where high capital intensive nature is a choice (streaming, software, etc.). Looking at the current companies, the power they hold, and their ability to keep the market share, one can decide how capital intensive his company or project should be.
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