Nature of Industry

Certain industries, such as automotive manufacturing, refining, and transportation require high levels of capital assets. Others, such as consulting, require very little in the way of capital assets. Other industries fall somewhere in the middle of these two extremes.

Effectiveness of Capital Process

Companies that require substantial investments in capital assets must develop effective decision and control processes over capital spending and asset management. Key process controls will include review of proposed expenditures to ensure business and economic justification, reviews to monitor project implementation, postaudits, physical control over existing assets, and identification and disposal of underutilized assets. The process of making capital investment decisions is discussed in detail in Chapters 20 and 21.

Vertical Integration

Vertical integration refers to the extent to which a company directly owns supply chain activities and resources. A company that is considered vertically integrated will produce a substantial part of the final product. An example of a vertically integrated organization would be a company engaged in growing, harvesting, processing, and distribution of food products. Other companies, by contrast, will purchase or acquire a substantial part of the product from third parties, commonly referred to as contract manufacturing or outsourcing. In recent years, there has been a strong movement toward outsourcing activities such as manufacturing, so that the enterprise can focus attention and resources on core activities such as product design and marketing. A company that outsources a substantial part of its manufacturing will require substantially less plant and equipment (and of course inventory) than a company that is more vertically integrated.

Depreciation Policy

Capital assets are defined as assets with a utility greater than one year. Accounting practices require that these investments be “capitalized” (recorded as assets) and depreciated over an estimated useful life. While there are general guidelines for depreciation methods and periods for each type of asset, companies can adopt either a conservative or an aggressive practice within the acceptable range. Companies that use shorter lives and faster depreciation methods will depreciate assets faster, resulting in higher depreciation expense and lower book values for these assets on the balance sheet.

Effective Capital Review and Approval Process

A fundamental driver of effective utilization of capital is the strength of the capital investment process. Figure 18.2 recaps key steps in an effective capital investment process.

Companies should identify potential capital projects as part of their strategic and annual operating planning activities. The capital budget will be an important element of each plan. For strategic plans, the managers should look out three to five years and anticipate significant capital expenditures to support growth, strategic initiatives, and other requirements. Integrating the capital plan into the financial projections will afford the opportunity to review cash flow projections and determine the adequacy of returns over the strategic planning horizon.

For significant expenditures, a capital investment proposal (CIP) should be prepared to document key aspects of the project, including business justification, economic case, alternatives, and implementation plan. The scope of the CIP and the management approval level should scale with the size and importance of the project. The CIP would typically include:

• Business case
• Economic case
• Alternatives
• Implementation plan

If a capital project has been supported by a well‐documented proposal, including a detailed implementation plan, managers can review the progress of the project at various points. Is the project on schedule? If not, why? Have the underlying assumptions changed? If so, is the project still worth doing? The capital investment decision process is covered in detail in Chapter 20.

Postimplementation Review

A terrific way to improve the utilization of capital and the capital investment process is to review the actual performance of capital investments compared to the original CIP (see sidebar: “Postaudit Review of Projects”). While this can be a difficult exercise for many projects, there is great value in the effort. First, managers will know, in advance, that the project results will be formally evaluated. This will encourage well‐thought‐out and realistic proposals. Second, even where the results may be difficult to measure, much can be learned about the project results as well as lessons for future projects. Third, the review can identify improvement opportunities in the capital investment process or management issues such as unrealistic projections or inadequate project oversight.

My first attempt at postimplementation reviews of capital projects was both difficult and modest. Managers complained that they didn't have adequate systems to measure the incremental savings for many projects. So we simply met to discuss the project and physically inspected the asset, where appropriate. On one occasion, we discovered that a substantial piece of equipment had been essentially abandoned shortly after purchase. We were able to sell the equipment, generating cash and reducing asset and depreciation levels. We also worked with the managers to ensure that the process to develop capital project proposals was improved to decrease the chances of this occurring in the future.

Asset Inventory and Utilization Review

Periodically, companies should perform a physical inventory of fixed assets and compare to accounting records. This process should be part of a company's internal control framework. The inventory can easily be expanded to review the estimated utilization of significant assets. If certain assets are not utilized, these assets may be sold (or otherwise disposed of), which will generate cash, reducing associated expenses (e.g. taxes, depreciation, maintenance, and insurance), and increase asset turnover.

In some cases, an asset's fair value may appreciate significantly over the value carried in the accounting records. This occurs frequently with real estate assets. Management should consider if the potential value realized by liquidating that asset exceeds the value of continuing to hold and operate that asset. Table 18.1 illustrates an asset utilization recap for the top 20 line items in property, plant, and equipment.

Ensure Key Business Decisions Include Capital Requirements

Frequently, capital requirements are not fully considered in business decisions. This is may occur in companies with a narrow focus on sales and earnings per share (EPS) growth and in companies with cash surpluses. Capital is sometimes viewed as “free” in these situations because of the muted effect of capital on EPS (depreciation expense is spread out over several years) and limited alternatives for utilizing excess cash.

Capital Asset Intensity (Fixed Asset Turnover)

Capital asset intensity or fixed asset turnover is computed as follows:

For RMC in 2018,

This measure reflects the level of investment in property, plant, and equipment relative to sales. Some businesses are very capital intensive (i.e. they require a substantial investment in capital), whereas others have modest requirements. For example, electric utility and transportation industries typically require high capital investments. On the other end of the spectrum, software development companies would usually require minimal levels of capital.

Capital Asset Intensity at Cost (Fixed Asset Turnover at Cost)

This is a variation of the previous formula that uses the original cost of the assets instead of the net book or depreciated value. It may be more useful in those situations where capital remains employed far beyond the original depreciation period, or to level set comparisons across companies with different depreciation policies.

Capital Reinvestment Rate

One way of measuring the rate of investment in capital is to compute the ratio of capital spending to depreciation.

For RMC in 2018,

Changes in depreciation levels lag capital investment because assets are depreciated over several years. For businesses with little or modest top‐line growth, a reinvestment index of 1 or lower may be appropriate. For high‐growth businesses, capital expenditures will typically exceed depreciation, resulting in a high capital reinvestment rate.

Asset Write‐Offs and Impairment History

Significant charges to write off or write down assets may indicate an ineffective decision or implementation process for capital investment. Companies that have frequent asset write‐offs and impairment charges (and other nonrecurring charges) likely have an opportunity to improve capital investment, strategic, and related processes.

Intangible Asset Turnover

Intangible asset turnover is a ratio helps explain the overall measure of asset turnover. A company that has made significant acquisitions will have a larger intangible balance and lower asset turnover than a company that has grown organically. The measure provides an indication of how significant acquisition activity has been relative to sales levels, and is computed as:

For RMC, the intangible asset turnover is:

Goodwill Impairment Charges

Goodwill impairment charges result from acquisitions failing to perform to expectations that supported the original purchase price. Significant charges to write off or write down assets may indicate an ineffective decision or implementation process for business acquisitions. Companies that have recorded impairment (and other nonrecurring) charges likely have an opportunity to improve acquisition and strategic processes.

Performance of Acquisitions: Synergies and Strategic Objectives

One way to determine if the intangibles related to a specific acquisition are safe or will be required to be written down in the future is to track key performance indicators on the value drivers that are critical to the success of the acquisition. Examples include key integration milestones such as sales force consolidation, the introduction of new products based on combined technologies, sales growth resulting from distribution synergies, and headcount reductions. Achieving these objectives, as set out in the acquisition plan and reflected in the acquisition pricing, should result in a favorable impairment test result.