The Capital Investment Cycle: Capital Investment as a Business Activity

Introduction

Capital investment in non-current assets (sometimes called long-term assets) is the means by which businesses allocate
resources to produce, store, distribute, and administer the products they sell.

In this lesson you will build on your knowledge of assets and the asset conversion cycle, learning why and how those assets are
acquired. You’ll learn that most companies need to make capital investments in non-current assets to start up and maintain their
business, support growth, and be competitive. You will also learn that the providers of finance require a return from non-current
assets and that some are more suitable to debt financing than others. Finally, you will learn some of the common types of capital
investment and how they support the health of the business. The knowledge you gain in this lesson will help you understand non-
current assets at a practical level and determine whether a business is using and managing its resources effectively over their
lifetime so that they make adequate returns for their owners and lenders.

By the end of this lesson, you should be able to:

Define capital investment and its role in a company’s success.

Explain why fixed asset spending is considered an investment rather than an expense.
Explain the impact of capital investment on a company’s ability to grow and compete.
Differentiate between common types of capital investments and their suitability in the context of a company’s
circumstance.

Capital Investment in Non-Current Assets

NOTE: Lessons contain links to additional content to help you to grasp concepts and perform well in your assessment. Please
ensure you review.

What You Need to Know

You should know that businesses must have long-term assets to support sales, enable the company to create its products or
deliver its services, and generally add value to the enterprise. You should also know that acquisition and maintenance of these
non-current assets is part of what we call capital investment. Read the following information to learn more about capital
investment as a business activity.
Role of the Capital Investment Cycle

Capital investment is the means by which companies acquire the long-lived capital assets needed to start, sustain and
grow their businesses.
Capital investment comprises expenditure on non-current assets such as property, plant, equipment (commonly called
Fixed Assets) and development of new products that benefit the business and generate cash flow over more than one
year.
All businesses require non-current assets. An electric utility company, for example, requires a power generation plant and
an electricity distribution system, whereas a consultant requires a car, a laptop and software.
Non-current assets have a finite ability to support the needs of a business. They undergo a cycle of acquisition, use,
maintenance, retirement and replacement.
When an asset has reached the limit of its capacity, the business must invest in additional assets to support further growth.
For example, a machine shop has a lathe for turning parts. To increase output, the lathe might be used more frequently;
however, it will eventually be used at its maximum capacity. Further expansion will require one or more additional lathes.
Likewise, expansion into new areas will require new non-current assets. For example, an in-town retail store might have a
catchment area of that town and its outlying neighbourhoods. If the business wants to expand into a new town, it will need
a new store.
Non-current assets have limited lifespans; they wear out with use or become obsolete over time.
Regular maintenance and repair can help maintain assets, but eventually almost all non-current assets cease to generate
adequate returns and thus require replacement.
To compete and grow, companies must maintain, replace, and expand their non-current asset base.

The Capital Investment Cycle

Fixed Asset Spending as Investment

Purchases result in either an immediate expense to the business or an asset creation.

Many expenses result from the using up of an asset. For example, if a company buys paper for its printers, the paper is an
asset until it is used, at which point it becomes an expense. In this case, the cycle between purchase and use of paper is
likely to be so short that is to be treated as an immediate expense. When a non-current asset is used up over a long period
of time (by definition, more than one year), it is initially recorded as an asset that is subsequently expensed through its use
by charging depreciation.
There are certain items with the characteristics of assets but Business books them as expense because their cost is too
insignificant for the business to capitalise (that is, record them on their balance sheets). Tablet computers, nuts and bolts in
engineering units are examples of such an asset.

Show Example: Fixed Asset Spending as Investment

 A truck purchased by a transport company will be operated for perhaps 15 years transporting products and
generating income for the company. The investment in the truck is recorded as an asset. As the truck wears out, the
value of the asset diminishes every year, and an expense reflecting that value reduction is recorded by way of
depreciation.

When the truck is recorded as an asset in the balance sheet, we are able to compare the investment in the truck
with the income it helps to generate each year. If, instead, the truck were expensed on acquisition, we would be
unable to relate the cost of the truck to the income generated by it in future years.

Common Types of Capital Investments

Businesses make many different types of capital investment. The reasons for investments differ, as does their
attractiveness to a lender.
The table below shows that non-current assets need not be physical in nature, but can be intangible or financial. Operating
assets are those assets that the company operates itself in its day-to-day activities. Note that a financial institution would
view investments in equity shares and bonds as operational, whereas an industrial unit would view such investments as
non-operational.
Lenders are generally willing to support the financing of physical operating assets, because their tangible nature makes
them easier to identify and establish control over (or ownership). They can be more reliably valued than intangible assets
and can be held as security or sold in the event of default. In addition, the returns they make are within the control of the
company.
Because of the less substantial and uncertain nature of intangible assets, lenders generally view them as higher risk and
therefore less attractive.
Debt is not generally used to finance non-current, non-operating assets of businesses, such as investment property and
equities, because the owner does not add value to the business by owning them.

Show Common Types of Capital Investment and Their Nature

Type of Asset Examples Nature Purpose Financing

Acquisition of property, Factory building, Physical Operational; business Debt and equity
plant and equipment manufacturing (tangible) start-ups, expansion,
equipment growth into new
markets

Replacement of property, Modernisation of Physical Operational; to Debt and equity

plant and equipment textile unit or (tangible) maintain existing
part of an capacity or expansion
existing asset

Development of new New drug, new Knowledge- Development of new More likely equity or
non-current assets type of car based operating processes retained earning
(intangible) and new products,
until enabling expansion
developed into new markets or
more efficient working
or growth

Intangible assets Software, Intangible Operational; to enable More likely equity or

patents, business processes, retained earning
trademarks, protect knowledge or
copyrights, etc. use the intellectual or
brand property of
others
 Investment property Premises held Tangible/ Non-operating; to earn Equity or retained
for capital gain financial a return on funds earning
or rental return surplus to operating
requirements (unless
the company is a
property investment
business)

Equity shares and bonds Listed securities Intangible/ Non-operating; to earn Equity or retained
financial a return on funds earning
surplus to operating
requirements (unless
the company is a
financial institution)

What You Need to Do

You should know that financial statements are a prime source of information about investment in non-current assets. You must
review the information they contain to understand what assets are held, how they are used and how they have been financed.
The following activities will help you do this effectively.

Review the company’s financial statements in detail to understand all you can of its assets, how
they’re financed and how they’re used. Ask management about any issues that are unclear.
Determine the nature of non-current assets that you expect the business to hold.
Read what management has to say about business performance in the current year and their
plans for the future; determine the role that non-current assets will play.
Review the notes relating to non-current assets to understand which non-current assets are in
use and what additions have been made to these.
Examine the relationship between the investment in non-current assets, the sales they support
and the costs of operating them.
Scrutinise other notes to establish the extent of commitments to purchase fixed assets in the
next year.
Be careful about non-operating Non–Current assets and find out specific reasons for holding
such assets. Find out if these are drain on Firm’s profit or these are means to siphon off the
funds.

How This is Useful

Understanding the nature of assets in detail and how they are used and financed can help you identify risks and lending
opportunities. The following example illustrates this concept.

Capital Investment as a Business Activity: Example

Mittal Plastics is a family-held private company manufacturing specialised plastic bottles. Mittal Plastics holds a current account
and overdraft facility with your bank. During 20X3 the company had, for the first time, used its line of credit, which has now nearly
reached its limit. Early in 20X4, you obtained the financial statements of Mittal Plastics, which are summarised in the following
table.

Extracts from Mittal Plastics’ Financial Statements

On reviewing the financial statements, you notice a number of issues. You follow up by carefully reviewing the notes.

There has been a significant increase in fixed assets (part of property, plant and equipment) that is explained by an extension to
the premises to increase capacity.

You would have expected an increase in machinery and equipment to fill the additional space, but you cannot find evidence of
their purchase. However, you find a note under capital commitments stating that the business has committed Rs. 60 lacs to
purchase new injection moulding equipment in 20X4.

You have concerns that the extension and future additions will be financed by operating cash flows and result in squeezing
customers and suppliers. This tactic is both insufficient and unsustainable, given the overdraft and fall in profitability in the current
year.

From your review, you decide that you must discuss with management their plans for expansion, put in measures to protect the
overdraft, and consider whether there is an opportunity to arrange a longer-term financing solution to support their plans.

Questions You Should Ask

Asking the right questions will help you make an efficient and sound analysis of the nature, purpose, and condition of non-current
assets. For example, you should ask the following questions:
 How capital-intensive is the industry in which your borrower operates, and what types of non-current operating
assets would you expect such a business to hold?

What are the prospects for this industry and the business, and how will that affect the company’s need to grow non-
current operating assets?

How much spare capacity might the business have in its existing non-current assets?

How much has the business spent on fixed assets in the past year? How much is it considering spending on
additional fixed assets in the coming year?

How have capital additions been financed in the past, how are they being financed currently, and how will they be
financed in the future?

Are plans for capital spending aligned with what managers say about their business strategy and what you know
about the industry?

Knowledge Check

Question 1
What is the correct term for the acquisition and maintenance of long-term assets?

Equity financing

Capital investment

Working capital

Operational expenditure

Businesses must have long-term assets such as machinery to create products and vehicles to deliver them. The acquisition
and maintenance of these types of assets is called capital investment.

Question 2
From a capital investment perspective, which activity must a business perform to grow and remain competitive?

Maintain, replace, and expand its non-current asset base.

Take in cash inflows greater than expenses.

Write off trade receivables that become uncollectible.

Build up inventory prior to the primary selling season.

To compete and grow, companies must judiciously maintain, replace, and expand their non-current asset base.

Question 3
Which purchase should be recorded as an asset rather than treated as an immediate expense?
 Toner cartridges for the printer

Photocopy paper

Combination bulk copier and printer

Postage stamps

Purchases result in either an immediate expense to a business or an asset. The copier/printer should have a life of more than
a year and will be classified as a non-current asset that is expensed through its use.

Question 4
For which asset would a lender prefer to provide financing?

Designs and drawings of a windmill unit

Investment properties

Goodwill arising on the acquisition of a business

Machinery and equipment

Lenders are generally willing to support the financing of physical operating assets because their tangible nature makes them
easier to identify and establish control. Because of the less substantial and uncertain nature of intangible assets, they are
generally viewed as higher risk and less attractive to lenders. Debt is normally not used to finance non-current, non-operating
assets of the business, such as investment in properties.

Question 5
Which feature dictates whether a particular asset will be expensed when it is purchased or recorded as an asset?

The amount of the purchase price

Whether the asset is tangible or intangible

The time between purchase and using up of the item

Whether the asset is new or used

An expense is essentially the using up of an asset. If the cycle between purchase and use is short, it is treated as an
expense. If an asset is used up over more than one year, it is recorded as an asset that is expensed as it is used.

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