Accounting and Capital

A simple way to understand capital investments

Photo by Nick Fewings on Unsplash

At the beginning of my career, I was able to see how some concepts of finance, accounting, and management can be brought all together to make sense of current and future scenarios.

While Argentina was melting down, I worked at a company that required heavy capital investment. It is natural to try to stop investing during a crisis, among the many measures management can implement including the never happy salary reductions and stopping most or all projects, stoping capital investments could be a pernicious one.

But how does management know investments are enough to serve the same capacity that is being served today? What are the measures or benchmark management can use to ensure the company can still serve the same markets and clients in the future?

One way to accurately calculate that level of investment is by using amortizations and depreciation as a proxy for what should be invested in the company on a yearly basis. For those who are not strong in the field of accounting, depreciation and amortizations are concepts that represent the loss of value of an asset, which is a machine, a building, or something else used to produce and create value.

In general assets are depreciated over time, say a building that is worth $1,000, and that lasts for 20 years will be written off the books at a rate of $50 per year. Now, per the explanation above, if the company is not at least investing $50 a year in buildings, there will be a moment when the company will not have a building anymore.

There are multiple caveats that accountants go through as part of the proper accounting of depreciation and amortizations, such as the impact of maintaining the building operational, the right amount to recognize in such expenditures, the correct number of years to use in the calculations and many others that are part of the nitty-gritty trade of CPAs.

Moreover, it is easy to see that the minimum required to invest to sustain capacity can be benchmarked against a proxy that shows how capital is being depleted.