Financial ratios are important indicators of a company's financial health. If you are a potential investor, taking a look at the company's financial ratios is vital before taking the next step. The capital intensity ratio, in particular, will tell you a lot about the company's ability to produce revenue based on asset investment.
Capital Intensity Ratio
The capital intensity ratio is a financial ratio. This ratio measures the ability of a company to effectively use its assets. Essentially, capital intensity shows how much of an investment in fixed assets was required during a given period to produce $1 of sales revenue. The actual ratio formula to measure capital intensity is total assets divided by sales revenue for a specified period.
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One way to understand this concept is to walk through an example. Assume that Company A wants to measure its capital intensity at year end. Company A has $750,000 in total assets and total sales revenue of $250,000. Company A's capital intensity ratio is 3.0 ($750,000 divided by $250,000). Company B is in the same industry as Company A and has $500,000 in total assets and $300,000 in sales revenue for the same period. Company B's capital intensity ratio is 1.67 ($500,000 divided by $300,000). When comparing the two companies, Company A is more "capital intensive" than Company B.
When a company's capital intensity ratio is high, it is said to be capital intensive. When a company is highly capital intensive, this means that the company has to make a significant investment in assets relative to the amount of sales revenue those assets can produce.
If a company has a high capital intensity ratio, that company will have high depreciation costs because of the number of assets. That company also will most likely have high liabilities related to loans for the large number of assets. If a company in a particular industry must have a high number of assets to produce relatively low sales revenue, this would be considered a hindrance to an entrepreneur wanting to enter the industry. The capital intensity ratio is important because it helps show a company's dollar return (e.g. sales revenue) on investment (e.g. purchase of assets).
Financial ratios can be excellent measures for potential investors. You must know how to read them effectively in light of particular industries and financial climates. Taking an online course on financial ratios and ratio analysis is a good way to get your feet wet.