Some businesses can grow for years with only modest investment in equipment. Others need to keep buying machinery, vehicles, buildings and systems just to stay where they are. The difference has a large effect on how much money is ever available to the owners.
Two numbers make this visible: depreciation on the income statement and capital expenditure on the cash flow statement. Warren Buffett and the Interpretation of Financial Statements treats both as important clues to whether a business has a durable competitive advantage. This article explains each, works through the arithmetic, and draws out what capital intensity means for anyone running or starting a business that depends on physical assets.
What depreciation is
When a business buys a machine expected to last ten years, accounting rules do not record the whole cost as an expense in the year of purchase. Instead, the cost is spread across the machine’s useful life as depreciation. A $500,000 machine expected to last ten years, with no residual value, might be depreciated at $50,000 a year under the simplest (straight-line) method.
Depreciation applies to tangible assets such as plant, equipment, vehicles and buildings. A similar process for intangible assets, such as acquired patents or software, is called amortisation.
Common methods
Businesses choose a method that reflects how an asset is used up:
- Straight-line: the same amount every year. Simple and widely used.
- Diminishing value (reducing balance): a fixed percentage of the remaining value each year, so the charge is larger early and smaller later. This often matches equipment that loses value fastest when new.
- Units of production: the charge follows actual use, such as machine hours or units made. Useful when wear depends on output rather than time.
The method and the estimated useful life are management choices, disclosed in the notes to the accounts. Longer assumed lives produce smaller annual charges and higher reported profits, so it is worth checking whether a company’s assumptions look realistic compared with its competitors.
Tax depreciation is a separate matter. Tax rules set their own effective lives and sometimes offer concessions, including for small businesses, and those rules change from time to time. The figures in the accounts and the figures in a tax return can therefore differ. For tax questions, check current rules with an accountant.
Why depreciation is a real cost
No cash leaves the business when depreciation is recorded, so it is tempting to treat it as a paper cost. Some popular measures, such as EBITDA (earnings before interest, tax, depreciation and amortisation), leave it out altogether.
The book argues firmly against that view. Machines wear out and must be replaced. Depreciation is the business’s way of acknowledging that the replacement bill is coming. Ignoring it makes heavy-asset businesses look more profitable than they are.
In fact, depreciation may understate the true cost. It is based on the original purchase price, but replacing a machine years later usually costs more because of inflation and technological change. A business that sets aside only its depreciation charge may find it cannot afford the replacement when the time comes.
Depreciation relative to gross profit
The book notes that companies with durable advantages tend to show depreciation that is small relative to gross profit, often single-digit percentages in the examples it discusses, while capital-heavy businesses in competitive industries can see depreciation absorb a large share of it.
This ratio is a useful quick check alongside the overhead and research ratios discussed in the previous article. Together they show how much of each dollar of gross profit is consumed before the business earns anything for its owners.
Capital expenditure: the cash version of the same story
Capital expenditure, often shortened to capex, is the cash actually spent on long-lived assets in a period. Where depreciation spreads the cost out, capex shows the cash leaving the business. It appears in the investing section of the cash flow statement, often as “payments for property, plant and equipment”.
The book offers a rule of thumb: compare capex over several years with net earnings over the same years.
- A business that consistently spends less than about 25% of its net earnings on capital expenditure is a strong candidate for having a durable advantage.
- Up to about 50% can still be consistent with a good business.
- A business that regularly spends more on capex than it earns is effectively running to stand still, and must fund the shortfall from debt or new shares.
Ten years is a sensible window, because capital spending is lumpy. A single new factory can distort any one year.
Working through the arithmetic
Here is an illustrative ten-year comparison of two businesses, each earning a total of $100 million in net profit over the decade.
| Business A | Business B | |
|---|---|---|
| Net earnings over 10 years | $100m | $100m |
| Capital expenditure over 10 years | $20m | $130m |
| Capex as a share of earnings | 20% | 130% |
| Cash left for owners, debt reduction or new investment | $80m | −$30m |
Business A spends a fifth of its earnings maintaining and expanding its assets, leaving $80 million available. Business B spends more than it earns. Despite reporting the same profits, it ends the decade $30 million further in debt or with $30 million of new shares issued.
These are illustrations, not real companies, but the pattern is common in practice. Reported profit is not the same as money the owners can actually use.
Finding the numbers
For a listed company, the annual report contains everything needed:
- Depreciation and amortisation usually appear on the income statement or in the notes, and are often added back in the operating section of the cash flow statement.
- Capital expenditure appears in the investing section of the cash flow statement, typically as payments for property, plant and equipment, and sometimes separately for intangible assets such as capitalised software.
- Net earnings come from the bottom of the income statement.
Add up capex and net earnings across as many years as you can find, then divide one by the other. Repeat the exercise for direct competitors. The comparison often says more than the absolute figure, because it shows whether a business needs more or less capital than others in the same industry to earn the same profit.
Maintenance capex and growth capex
Not all capital spending is the cost of standing still. It helps to distinguish:
- Maintenance capex: spending needed to keep existing operations running at their current level, such as replacing worn equipment or updating systems.
- Growth capex: spending to expand capacity, enter new markets or add new capabilities.
Companies rarely report the split, but the distinction matters. Growth capex in a business with good returns can be an excellent use of money. Maintenance capex is a cost the business must bear just to remain in place.
One rough way to estimate maintenance capex is to compare capex with depreciation over many years. A business that spends roughly its depreciation charge is probably mostly maintaining; one that spends far more is either growing or facing rising replacement costs. Judgement and context are needed to tell which.
Why capital intensity matters so much
Capital intensity affects a business in several ways beyond the raw arithmetic.
Flexibility. A business with low capital needs can redirect cash quickly: into a new opportunity, through a downturn, or back to owners. A capital-heavy business has much of its cash committed in advance.
Risk. Heavy assets often come with heavy debt. If demand falls, the equipment and the loans remain, while revenue does not.
Competition. In capital-heavy industries, competitors also invest heavily, often adding capacity at the same time. Excess capacity drives prices down, which is one reason industries such as airlines, shipping and commodity production have historically struggled to earn consistent returns.
Technological change. When technology moves quickly, equipment can become obsolete before it is worn out, forcing replacement earlier than planned.
Heavy assets can still be good businesses
Capital intensity is not automatically bad. Some excellent businesses are capital-heavy: railways, pipelines, utilities, certain manufacturers. What distinguishes the good ones is that their assets create an advantage competitors cannot easily match: a network that would be impractical to duplicate, a regulated position, or a scale that delivers genuinely lower costs.
The question is not whether a business has heavy assets, but whether those assets earn a good return and protect a lasting position, or simply allow the business to keep competing on equal terms.
What this means for manufacturing ventures
GoCore’s interests include physical products and manufacturing, where capital intensity is a constant question. Some lessons apply directly.
Count the replacement cycle from day one. Equipment has a working life. Budget for its replacement as a real, recurring cost, not a distant event. A simple annual “replacement reserve” equal to at least the depreciation charge is a sensible discipline.
Prefer flexible capacity early. Contract manufacturing, shared facilities, leased equipment or modular systems can keep capital needs proportionate while demand is still being proven. Owning everything from the start ties up cash that a young business may badly need elsewhere.
Invest where it creates an advantage. Capital spending that lowers unit cost below competitors, enables something they cannot do, or dramatically improves quality can build a durable position. Spending that merely matches competitors usually does not.
Watch capex against earnings, not against ambition. Expansion is easy to justify in a plan. The test is whether the business can fund it from its own earnings over time.
Consider utilisation. Equipment that sits idle half the time doubles its effective cost per unit produced. Before buying more capacity, check how fully existing capacity is used.
Think about obsolescence. For equipment tied to fast-changing technology, a shorter planning life and flexible financing reduce the risk of being stuck with outdated assets.
Leasing, renting and outsourcing
Many small businesses face a choice between buying equipment, leasing it or outsourcing the work entirely.
| Option | Advantages | Disadvantages |
|---|---|---|
| Buy | Lower long-run cost if fully used; control | Large up-front cash; obsolescence risk |
| Lease or rent | Lower up-front cost; easier upgrades | Higher long-run cost; ongoing commitment |
| Outsource | No capital; capacity scales with demand | Less control; supplier margin; dependency |
There is no universal answer. Early in a venture, preserving cash and flexibility often matters more than minimising long-run cost. Once demand is proven and stable, ownership may become the better choice. Note also that under current accounting standards most leases appear on the balance sheet, so leasing does not make capital commitments disappear from the accounts.
A worked example
A small business makes custom architectural metalwork. This is an illustration.
In its first year, the owner considers buying a $400,000 laser cutter. Instead, she outsources cutting to a larger fabricator at a premium, keeping her own capital for welding equipment, a modest workshop lease and working capital. Over two years, she learns which jobs are most profitable and how much cutting she really needs.
By year three, outsourced cutting costs $150,000 a year and the volume is stable. A cutter now makes sense: depreciation of around $40,000 a year plus operating costs comes well below the outsourcing bill, and owning it shortens lead times, which customers value. She buys it, funded mostly from accumulated earnings rather than debt.
The decision was the same piece of equipment, but the timing changed it from a risky bet into a sound investment.
Common mistakes
Treating depreciation as a non-cost. It is the replacement bill arriving in instalments.
Relying on EBITDA. It flatters capital-heavy businesses.
Comparing one year of capex with one year of earnings. Capital spending is lumpy; use five to ten years.
Buying capacity before demand is proven. It ties up cash and adds risk.
Ignoring rising replacement costs. Today’s depreciation is based on yesterday’s prices.
Questions to ask
- Over ten years, how does capital expenditure compare with net earnings?
- How much of capex is maintenance, and how much growth?
- Does depreciation consume a large share of gross profit?
- Do the assets create an advantage, or just keep the business level with competitors?
- For your own business: could you rent, lease or outsource instead of buying, at least until demand is proven?
Bringing it together
Depreciation and capital expenditure show how much of a business’s earnings must be ploughed back just to keep its assets working. Businesses with durable advantages typically need relatively little: their earnings flow through to owners rather than into ever-replacing equipment. Capital-heavy businesses can still be excellent, but only when their assets create a position competitors cannot match.
For anyone building a business with physical assets, the lesson is to treat capital as precious: keep it flexible until demand is proven, count the replacement cycle as a real cost, and invest where it builds an advantage rather than where it simply keeps pace.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Figures in this article are illustrations, not data. Accounting treatment is summarised generally; consult a qualified accountant for specific situations. This article is general information, not financial or investment advice.
