What Is Capital Efficiency?

Capital efficiency has to do with understanding the ratio of output in comparison to the amount of capital expenditure involved in maintaining the operation of a business or a product line. This simple comparison serves as a way to determine if a particular operation should be continued as is, continued with some adjustments, or abandoned and the resources diverted to other projects.

The basic formula for calculating capital efficiency involves dividing the average value of output by the rate of expenditure for the same period of time. Output divided by expenditure will help to make it clear if a venture is currently generating a modest profit, is approaching a point where profitability will be realized once expenditures are decreased, or if there is no real value in continuing to fund the venture. While the latter situation is one to avoid at all costs, the two former possible states are not situations that should be considered negative.

Because many business ventures begin with a higher level of capital expenditures, a project rarely realizes a profit in the first stages of the operation. The expectation is that after the initial launch, some expenses will be settled and not be recurring. As the rate of expenditure decreases and the output or production increases, the opportunity for profit expands. For this reason, periodic calculation of the capital efficiency of a project can help investors know that the project is heading in the right direction.

Once this forward trend results in the realization of a small profit, factoring the capital efficiency can still contribute to tracking the gradual increase in profits. Capital efficiency can also help refine the production process, by alerting officers of the project that there may be additional areas where expenses can be cut without harming the quality of the product and realize an even greater profit. Periodic calculations of the capital efficiency during the life of the project can also call attention to trends that are negatively impacting the project, allowing time to make changes before a profitable venture devolves into a project that is losing money.

Capital expenditures often have high costs because they include maintaining, improving or purchasing tangible fixed assets. These fixed assets (property, plant and equipment, also known as PP&E) may consist of land, supplies, technology, buildings or vehicles. The general formula for capital expenditures is the sum of any changes in fixed assets (the current value minus the prior value) plus current depreciation.

However, more complicated calculations may be necessary. For example, the company’s fixed assets should be noted from the previous year’s financial statements and subtracted from the current year’s fixed assets. Any intangible assets should also be subtracted. If the company purchased additional tangible fixed assets during the current reporting period, they should also be subtracted. This calculation is used to acquire the change in PP&E. Next, subtract the accumulated depreciation from the previous year from the current year's accumulated depreciation to get total depreciation. That number is then added to the PP&E calculation to get capital expenditures.

Depreciation and amortization can be found on the company’s income statement, while the value of its PP&E are located on the balance sheet. Prior values can be found on previous balance sheets. This information is also available on companies' cash flow statements.

Businesses pay their daily expenses using working capital, which can be damaged with unexpected costs. Inefficient working capital management can prevent a firm from delivering goods on time, purchasing inventory, paying bills or taking advantage of growth opportunities. However, there are ways to improve this efficiency.

The first step for most companies is to reduce their expenses. Any unnecessary expense should be cut. It is also possible to renegotiate loan or lease terms and pursue more favorable terms with vendors and suppliers. Then, businesses should pay their bills on time to reduce their debt servicing expenses and meet their obligations. In addition, companies can also search for tax incentives.

Some companies increase their working capital flexibility through their accounts receivable. When their working capital is low or an unexpected expense arises, these businesses sell their accounts receivable or borrow against them to improve their current situation. Unfortunately, this can backfire because it may adversely affect long-term finances.

Many businesses offer their customers credit to increase their audience, order size and returning customers. However, if these accounts are given without a proper credit check, a company may offer credit to individuals who will either pay their account late or never pay it at all. Although it may cost to pull a client’s credit report, these reports allow business owners to make more informed credit decisions because they reveal their clients' past credit and payment histories, bankruptcies and tax liens.

Companies should also conduct a risk analysis when working with foreign entities. Because the financial structures of foreign trade and multinational organizations are complex, consulting with a risk expert may help these owners assess how extending credit can affect their working capital efficiency.

Businesses should seek to decrease bad debt by reducing collection periods, implementing automated digital collection processes, offering incentives for faster payments and penalizing late payments. Organizations can also combat bad debt by selling products with higher margins, increasing margins across all products and reducing inventory through implementing just-in-time logistics strategies.

Companies should avoid purchasing fixed assets using working capital because they deplete this account quickly. Instead, they should seek a long-term loan or lease. This leaves the company with the working capital it needs for projects.

Organizations should build relationships with their banking institutions through open communication. This transparency allows them to take advantage of lower interest rates and risk assessments.

The marginal efficiency of capital reveals how well an investment will do. It is the rate of return a project is expected to provide compared to current interest rates. For example, if the current rate is 5%, the company’s project needs to have at least a 5% rate of return to make it worthwhile.

The interest rate is important because most firms will borrow or deplete their savings to start new projects or purchase equipment. The interest that would have been earned by saving the money is the opportunity cost, and this cost must be below the actual earnings of the project to make it profitable. Therefore, projects started during periods with lower rates are more attractive than those started during periods with higher rates.