Capex-to-Depreciation Ratio: a Worked Example

A business that stops replacing equipment looks better for a while. Capital spending falls, so free cash flow rises; depreciation carries on, so profit is unchanged. Nothing in the income statement records that the plant is getting older. The cost arrives later, as a breakdown, a quality failure or a replacement programme that has to be funded at once. A lender repaid over five or seven years cares about that timing, because the deferred spending may fall due inside the life of its loan.

The reporting standards point at the same question. IAS 7, as adopted in New Zealand and as AASB 107 in Australia, encourages, without requiring, separate disclosure of the cash spent to maintain operating capacity and the cash spent to increase it, so that a reader can judge whether a business is investing enough to keep what it has. Few mid-market accounts make that split, so the lender builds its own reading, starting with this ratio.

Each side has to be clean before the division means much. Capital spending comes from the investing section of the cash flow statement or the additions column of the asset note. Depreciation should be for the same assets: amortisation of acquired intangibles is usually left out, and so, often, is depreciation of leased assets, for a reason the example shows.

Four things distort the charge. It is based on what assets cost when bought, so after years of inflation it understates replacement cost. It rests on useful lives the business chooses, which under IAS 16 are reviewed each year end, and lengthening them cuts depreciation and lifts the ratio with no money spent. Accounts prepared on a tax basis, common among smaller private companies in New Zealand and Australia, may use tax rates rather than economic lives. And an asset that is fully depreciated but still running adds nothing to the charge, so an old plant can show a ratio that looks healthy.

A fruit-juice processor, constructed for this page like every figure in it, runs presses, pasteurisers and a bottling hall. Its depreciation on owned plant and its capital spending over five years are below, in US$m. In year 5 it also replaced its old bottling line with a leased one, recognising a lease liability of US$3.0m and lease depreciation of US$0.5m; the lease is not in the cash flow statement's capex.

Over five years the processor spent US$14.9m against US$20.6m of wear, a shortfall of US$5.7m. Part of it is the bottling line, which was renewed through a lease rather than bought: read as the renewal it is, year 5 looks like a year of reinvestment, not neglect. The rest is in the press hall. The asset register shows two presses, bought 21 years ago for US$1.6m between them, fully depreciated and still in use. They add nothing to the charge, so the ratio understates the gap, and the supplier's quote to replace them is US$3.4m. The figures are the example's, not a market norm.

The ratio mixes two kinds of spending. Maintenance capex keeps existing capacity working; growth capex adds capacity the business did not have. A processor that spent heavily on a new line would score above one while its old presses were still left to age. So a lender splits the spending first, then reads what remains against the charge, against the age of the main assets and against the share of their original cost already depreciated.

DEFINED IN ONE PARAGRAPH → · GROWTH CAPEX → · LEASES IN THE ACCOUNTS →

It decides the lender's own forecast. A borrower whose plan carries capex at half of depreciation for five more years is assuming its plant will last, and the lender's case replaces that assumption with a maintenance figure it can defend, here including the presses. The cash available for debt service falls accordingly, and so may the amount the bank will lend. It can also shape the document: a facility may fund the replacement as a separate tranche, or a capex covenant may set how much the borrower may spend.

For accounts in transition the lender also checks the basis. Lease depreciation entered the charge under IFRS 16 from 2019 in all three markets for IFRS reporters, and the revised FRS 102 brings most leases onto the balance sheets of UK companies reporting under it for periods beginning on or after 1 January 2026, so such a borrower's ratio can drop in its first year on the new basis with nothing changed in its plant.

HOW BANKS READ MANUFACTURING → · LENDER'S FREE CASH FLOW →