All businesses need capital: Capital is required to start a business; for it to continue as a going concern, it needs capital; and for it to grow, it needs capital. There isn't anything new to this story.
what we don't want
However, there are businesses which unfortunately require loads of capital to start, then loads of it to continue, and loads of it again to grow. It is the nature of the business, that's it. These will then have to look for sources of capital: equity and debt combinations. This continuous look out for large capital can make the firm vulnerable to circumstances.
Take for instance, capital goods manufacturing and heavy transport companies.
There are at least two characteristics, arising out of leverage, that stand out in such a capital-intensive business:
It has a high percentage of property, plant and equipment compared to its total operating assets. Due to this, it is exposed to operational leverage. In good times, with rising output, the profits will be higher. However, with a very low portion of variable costs, in a downturn the business will suffer.
Because of its capital needs, the business will have to borrow more compared to its equity. The firm will be able to (required to or tempted to) borrow based on its physical assets. The result is a high debt ratio.
Due to higher operational and financial leverage, a capital-intensive firm will find it very difficult to adapt to changes required by market conditions. Changes in technology or in consumer demand could challenge the firm's fundamentals.
A slump in the economy could lead the smaller firms to question their survival and the larger firms to question their prominence.
An investor has to be careful in investing in these type of businesses. Assessment of long-term survival is vital.
what we want
But how about a business that requires capital, but not that much, to grow? And how about one that generates its capital on its own?
Enough cash is generated by the operations which is used for reinvestment purposes, and excess cash is returned to shareholders.
These firms largely run on the strength of their brand created by high quality management and top quality products purchased more often (customer satisfaction; high demand). These businesses generally provide higher return of investment.
There are enough of these type out there, if not plenty; we just need to explore!
Let's get on to that.
what we don't want
However, there are businesses which unfortunately require loads of capital to start, then loads of it to continue, and loads of it again to grow. It is the nature of the business, that's it. These will then have to look for sources of capital: equity and debt combinations. This continuous look out for large capital can make the firm vulnerable to circumstances.
Take for instance, capital goods manufacturing and heavy transport companies.
There are at least two characteristics, arising out of leverage, that stand out in such a capital-intensive business:
It has a high percentage of property, plant and equipment compared to its total operating assets. Due to this, it is exposed to operational leverage. In good times, with rising output, the profits will be higher. However, with a very low portion of variable costs, in a downturn the business will suffer.
Because of its capital needs, the business will have to borrow more compared to its equity. The firm will be able to (required to or tempted to) borrow based on its physical assets. The result is a high debt ratio.
Due to higher operational and financial leverage, a capital-intensive firm will find it very difficult to adapt to changes required by market conditions. Changes in technology or in consumer demand could challenge the firm's fundamentals.
A slump in the economy could lead the smaller firms to question their survival and the larger firms to question their prominence.
An investor has to be careful in investing in these type of businesses. Assessment of long-term survival is vital.
what we want
But how about a business that requires capital, but not that much, to grow? And how about one that generates its capital on its own?
Enough cash is generated by the operations which is used for reinvestment purposes, and excess cash is returned to shareholders.
These firms largely run on the strength of their brand created by high quality management and top quality products purchased more often (customer satisfaction; high demand). These businesses generally provide higher return of investment.
There are enough of these type out there, if not plenty; we just need to explore!
Let's get on to that.
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