What is Capital Acquisition Ratio?
The Capital Acquisition Ratio measures a company’s capacity to fund its capital expenditures (Capex) requirements using its internal sources of cash, i.e. operating cash flow (OCF).
How to Calculate Capital Acquisition Ratio (Step-by-Step)
In capital budgeting, the capital acquisition ratio compares a company’s operating cash flow (OCF) to its capital expenditures (Capex) to determine if its core business activities generate sufficient cash flows to finance the purchase of fixed assets (PP&E).
The core objective of capital budgeting is ensuring that the projects and long-term investments undertaken by a company—i.e. its capital expenditures (Capex)—meet its minimum hurdle rate in terms of profitability and returns.
Therefore, the capital acquisition ratio, also referred to as the “cash flow to capex ratio”, is a method to confirm that the capital allocated towards the purchase of PP&E is a net positive to the company over the long run (i.e. value creation), rather than a net loss.
A project or investment that causes a net loss, i.e. deterioration in the total value of the company, would be signified by a cash flow to capex ratio of less than 1.0x.
The two required inputs of the formula, i.e. the company’s operating cash flow (OCF) and capital expenditures (Capex), can be found on the cash flow statement (CFS).
- Operating Cash Flow (OCF) → The operating cash flow, i.e. the cash from operations (CFO) section of the cash flow statement, is the net cash generated from a company’s core operating activities across a specified period. The calculation starts with net income, i.e. the accrual accounting profit metric from the income statement, before adjusting for non-cash items (e.g. depreciation and amortization) and the change in net working capital (NWC).
- Capital Expenditures (Capex) → The capital expenditures line item can be found in the investing section of the cash flow statement (CFS) and represents the purchases of fixed assets (PP&E) made by a company to maintain the current pace of growth and to facilitate future growth. The former describes “maintenance capex”, whereas the latter refers to “growth capex. While the spending categorized as growth capex is more discretionary, maintenance capex is the minimum spending required to support ongoing operations (e.g. the replacement of equipment).
Capital Acquisition Ratio Formula
The formula to calculate the capital acquisition ratio is as follows.
- Operating Cash Flow (OCF) = Net Income + D&A – Increase in Net Working Capital (NWC)
- Capital Expenditure (Capex) = Ending PP&E – Beginning PP&E + Depreciation
How to Interpret Cash Flow to Capital Expenditures Ratio
The general rules for interpreting the cash flow to capex ratio are the following:
- Cash Flow to Capex Ratio > 1.0x → The company’s operating cash flow (OCF) is enough to fund the required capex spending, with additional cash on hand available to allocate to more discretionary growth capital expenditures, or as a “cushion” to withstand periods of cyclically. The higher the capital acquisition ratio, the more discretionary cash flow the company’s operations generate, which can be reinvested into the business and on growth capital expenditures, i.e. the company’s outlook in terms of revenue growth upside should be perceived positively by investors and equity analysts alike.
- Cash Flow to Capex Ratio = 1.0x → The company’s operating cash flow (OCF) is sufficient to finance its current level of capex spending, however, it is likely in the company’s best interests to reduce its future spending. The margin for error presents a significant risk to the company, so implementing cost-cutting measures and increasing liquidity (i.e. via the sale of non-core assets) would be the right decision, especially if the company operates in a capital-intensive industry and most of its historical and projected capital expenditures fall under maintenance capex.
- Cash Flow to Capex Ratio < 1.0x → The company’s operating cash flow (OCF) is insufficient to fund its capex spending. Similar to the prior scenario, cost-cutting measures are urgently required. Until the company’s cash flow profile improves and its capacity to acquire long-term assets expands substantially, most of its capex spending should be cut back to consist of only maintenance capex (and no growth capex). Otherwise, the company is at risk of becoming illiquid, e.g. the capex could deplete the company’s cash reserves and cause it to potentially miss a required interest expense payment (and default on a debt obligation).