Today we are going to review what is a capital investment and what are its advantages and disadvantages for a business. For a company to grow, it is important to analyze different types of capital investment projects in order to invest in the most profitable ones. Every company, regardless of its size, requires at certain times to invest in itself to ensure its continuity and performance. For this, it is necessary to analyze in detail the investment required to improve and optimize its performance. This is the only way to guarantee its continuity and development.
In addition, capital investment is supposed to enable one or more of the following purposes: to provide initial or additional production capacity, to improve efficiency, or to replace assets at the end of their useful life. Therefore, it is important that a capital investment project contains all the possible variables that can influence it. Always relying on different financial tools such as cash flows or financial indicators to obtain the expected results and thus generate profits with the investment.
What is a capital investment?
A capital investment involves investing funds in a business to help it expand or improve its productivity. These funds are used by the company to acquire or build fixed assets. Assets that are expected to be used over a long period of time. Capital investment can take the form of debt, equity, or a combination of both. It can come from a variety of sources, including angel investors, venture capitalists, lenders, and public securities offerings.
With equity investment, the company obtains the funds it deems necessary to further its goals and objectives. In this way, it guarantees an improvement in its products and/or services, which translates into greater competitiveness in the marketplace and, in turn, increased revenues. But the capital investment must be made after a detailed analysis that allows establishing clearly and precisely the costs involved so that a profit is obtained and not a future loss.
Capital investment is generally a long-term investment. It involves the acquisition of assets that, although they are not the final objective of the company’s operating cycle, without their presence or operation it would not be possible to meet the company’s economic and financial objectives. Good administrative management must ensure continuous capital investment in order to maintain the company’s productivity, always at the highest levels without losing product quality.
How do they affect a company’s operations?
Capital investment is intended to benefit a company in the long term, but it may also benefit the company in the short term. However, intensive and constant capital investment tends to reduce short-term profit growth. Such moves are never well regarded by a company’s shareholders. In addition, the total amount of debt a company has on the books is a figure that stock owners and analysts follow closely.
During the process of raising funds and putting the assets into operation by the capital investment, the company’s normal operating cycle is likely to come to a standstill or run at a minimum. This implies a decrease in production and consequently revenues during this period also decrease. In addition, it could be the case that some jobs are left inoperative, resulting in disbursement in salaries without receiving the corresponding consideration.
However, once the capital investment has been made, the company’s operating cycle begins again with greater strength. This translates into better profits for the company, its employees, and investors. By improving, modernizing, or expanding a company, its operations are carried out with greater efficiency, and, in turn, the products and/or services are placed at the forefront; with improved response, capacity to meet the needs of customers.
Types of capital investment
Capital investment will depend on the company’s needs at a given time, once its asset conversion cycle has been analyzed. Taking these needs into account, three types of capital investment can be differentiated.
- Diversification: These decisions require the evaluation of proposals to diversify into new product lines, new markets, etc. To reduce the risk of failure when dealing with different products or operating in several markets.
- Replacement and modernization: Replacement and modernization investments are aimed at improving operating efficiency and reducing costs. Generally, all types of plants and machinery have a useful life, after which they must be replaced. At other times, technology creates more modern and efficient machinery, and the company must make the decision to modernize in order to remain competitive in the market. These replacement or modernization investments are also called cost reduction investments.
- Expansion: Many existing companies may experience growth in demand for their product line. If such companies experience shortages or delays in the delivery of their products due to inadequate production facilities, to stay in the market they must add capacity to the existing product. By investing in expansion, the company can improve its productivity as well as maintain production at the levels demanded by the ever-increasing demand. In this way, expansion guarantees the continuity of the company.
When does a capital investment cycle end?
Every company, regardless of its size, type, or area in which it operates, has an asset conversion cycle. That is, the cycle by which cash is used to prepare a product or service, sell it to a customer, and convert the sale into cash again. And, that cycle has two main components: the operating cycle and the capital investment cycle. The operating cycle includes a company’s normal operations, such as producing and selling goods or services and collecting cash from those sales.
The capital investment cycle includes the purchase and use of fixed assets needed to support day-to-day operations. By studying the business asset conversion cycle, you can understand why and when the company needs more cash to operate and when and how it will be able to repay that cash. The asset conversion cycle is a critical determinant of how much total capital a company may require and the excess cash flow to support loan repayment.
Advantages of capital investments
An equity investment is used to enhance a company’s current growth. Among the advantages that an equity investment brings to a company we can mention:
- Financial benefit: Undoubtedly, the addition of capital investment in the form of funds provides a clear financial boost to the business. When this occurs, it can help improve production efficiency, thus contributing to the economy as well. In addition, an improvement in production can lead to the option of hiring more employees, which generates jobs.
- Wealth generation: a capital investment well spent, and following the guidelines established in the investment project, helps the company grow and keeps it relevant in the market. This translates into wealth generation. When capital investment is made, there is better income for both management and employees, as well as for shareholders. In this way, new investment opportunities can be opened up in the future.
- Increased market competition: When a company faces a certain amount of competition in the market for a product or service, capital investment becomes necessary. The greater the competition, the better the quality of the product or service, which generates an increase in sales. A highly competitive company is an outstanding company in its field, which makes it attractive to both customers and future investors.
Disadvantages of capital investments
Making a capital investment in a business to acquire fixed assets, improve existing assets, or simply expand, requires a large sum of money. This capital investment can be obtained through several sources: the use of available cash, the sale of other assets, or the raising of capital through the issuance of debt or equity. Each of these sources of financing has its risks and disadvantages that the company must assume.
The first financing option for capital investment is always the company’s own operating cash flow. But this cash flow may not be sufficient to cover anticipated costs. In this case, the company could lose liquidity, and the cash flow, not being able to cover its costs, could become negative. This is a disadvantage and a risk that the company must assume and could harm the normal development of its activities.
On the other hand, if the capital investment comes from a loan, it must generally offer a guarantee for the loan. In this case, the collateral is compromised, as well as part of the working capital available for the payment of the installments. If, on the other hand, it receives the money from the sale of shares in the company, the partners or owners lose part of their autonomy and participation in the profits that the capital investment may generate.