Businesses prepare financial statements regularly to allow shareholders to judge their performance. However, these figures don't help much if you can't interpret them correctly. The capital expenditures to depreciation ratio helps you understand a business's current level of capital spending and predict the firm's future direction.
Both capital expenditure and depreciation deal with a business's long-term assets, such as machinery, vehicles and computers. For example, when a business purchases factory equipment, the business considers it a capital expenditure instead of an expense. Instead of claiming tax deductions on it immediately, the business depreciates it over its useful life. For example, if the piece of factory equipment is expected to last for seven years, the company declares its depreciation over seven years, claiming tax deductions on the depreciation. As such, the business spreads its tax savings over the length of the asset's useful life.
The capital expenditures to depreciation ratio usually covers a period of one year. Calculate it by dividing the business's capital expenditures by its depreciation, taking into account all the firm's capital expenditures and its entire depreciation amount over the year. For example, the firm may purchase five trucks for $100,000. In the same year, it depreciates two machines and 10 computers for $50,000. This business would have a capital expenditures to depreciation ratio of 2 ($100,000/$50,000).
The capital expenditures to depreciation ratio indicates the growth phase of the business. A high ratio shows that the business is investing highly in its long-term assets, implying an expectation of future growth or expansion. According to Goldman Sachs, the sales revenues of businesses with high capital expenditures to depreciation ratios grow more quickly than businesses with low capital expenditures to depreciation ratios. Businesses with high capital expenditures to depreciation ratios invest a larger portion of their resources in themselves so they can perform better than their competitors.
The average business has a capital expenditures to depreciation ratio of about 1. A firm that is growing often has a higher ratio, while a firm that is no longer buying long-term assets usually has a lower ratio. According to Goldman Sachs, the S&P 500 companies have averaged 1.4 in capital expenditures to depreciation ratio between 1989 and 2009. Usually, companies in the utilities and energy fields have the highest capital expenditures to depreciation ratios of between 1.8 to 2.1.
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