What is the lowest Capex to run the business?

One of the most challenging decisions, in capital intensive companies, is to decide how much capex will be disbursed to minimally run the business, especially when a crisis or a sudden decrease in sales rises.

The first question is: is this situation a one-timer, caused by a typical cycle, or it is structural for the company or industrial sector? Is this the first time this situation shows up? Commodity businesses, for instance, are cyclical. So is the real estate business. These cycles are strongly correlated with government monetary policies, inflation across the globe and extraordinary events in a connected and global world. Is this crisis affecting all the sector or even the country, or just the company? Is the only company facing financial problems, or the whole sector is experiencing the same issue?

This understanding is important before shutting down long-term cash generation industrial sites or reducing the sustainability capital expenses. Usually, the companies do not panic, but, to my mind, the capital expenditures decision game has some opportunities. When the yearly rolling forecast result is significantly lower than the budgeted one, the capital decisions would be better to follow a pre-established criteria or strategy.

Does your company know what set of sites really generates cash-flow in a long-term perspective? Shutting down some old, high-cost and cash flow taker sites were evaluated, in terms of a broader view of the company, before investing “good” sustainability capital in all the company`s assets just to keep then running? As per WEISSENRIEDER (2023) must-read “Redesigning Capex Strategy”, “(…) most of the companies do not look at their asset base as a collective network. They see their assets as stand-alone performers and the same thing with their capex opportunities.”

One thing to consider is that capex is a good thing. Entrepreneurs want to spend capital because they are the vehicle to value generation – at least in tangible asset-based businesses. Good performing sites should have more access to capital to continue thriving. Poor mills, however, would have to do more convincing story for the decision makers.

Does your company understand how much capital each cash generating industrial site requires to run (not necessary to grow)?

When it comes a time with a very limited EBITDA generation forecast (or even in profitable phases), the capital decisions related to sustainability could be:

1.???? According to each site`s capacity to generate EBITDA. This is a dangerous approach. Assets do not last forever. They have a life cycle. Assets do not care about the volume and sales prices. If they are not replaced in a proper time, they will surely fail someday. The problem related to reduce Capex in crisis, is that the decisions made do not create immediate results. And it is often difficult to connect failures, operational accidents and lower industrial assets performance to Capex decisions in the past.

1.???? A depreciation related criterion. The older the asset, usually more capital (and management`s attention) it will demand. In the first years of operation, usually only a few parts will have to be replaced. After 20 years, usually there is no depreciation in an accounting perspective, but the asset will require more capital than the beginning – more components and machines will need resources to keep running. Also, we have depreciation criteria considering, usually, 10 to 20 years life cycle. Some assets run more than 50 years (with proper maintenance). A high depreciation percentage in terms of capex allocation would be higher than the actual assets` requirements. So, using depreciation is a not such a good idea in terms of estimating sustainability capital.

2.???? Emotion or hierarchy. Some companies just cannot find a professional approach to prioritize or approve projects, and are victims of the hierarchy. The problem with this "method" is that the senior management cannot bring the best ideas all the time – at least, not for a long-term view, which is the most important for a company that aims to endure in a competitive environment.

3.???? Risk-related criterion. Some companies approve capex according to a risk level. If the undesirable future event (risk) is unacceptable under some criteria connecting probably and impact, the project would be approved. This can be a better approach than the previous ones, as it is a bottom-up one and it often reaches the equipment and life-cycle level. The problem with this approach is that, usually, the team who estimates the risk is the same that is exposed to it. If you ask a maintenance department to calculate the risk level of an equipment they are supposed to maintain, to submit a capex request, it will probably apply a very biased analysis (overestimating the risk). They do not have a very strong incentive to take high risks that would cost millions of dollars for the enterprise. A company that trusts heavily in this approach should search for unbiased and even an independent second analysis to avoid a very low risk appetite, which will lead to a very high sustainability capital and important cash-flow reduction. Another problem is that without a broader approach, the team will always have a corrective, not preventive, view. It is hard to see projects to replace equipment after three years from now. The team just does not have the time or the method to foresee such demand in a far future, as they are focused in the short-time production and performance indicators. This is a short-term approach – and in a crisis an exhausting cycle of discussions will take place to prioritize projects according to what area has the bigger risks. No one wants to receive a low Capex budget.

The suggested approach to determine sustainability capital, to my mind, is the asset mapping, as suggested by WEISSENRIEDER (2023).

In the asset mapping approach, the teams (usually the industrial, engineering and procurement departments, but not limited to these) are supposed to break an industrial site asset into equipment, machinery and other assets above a threshold. After the site is divided into smaller parts, considering equipment or set of equipment, the team will have to determine the useful life, how much will be the cost to replace it to a modern equivalent, and how much the equipment will require in terms of capex during this lifetime. The result, at the end, is a curve that shows the capital needs for the industrial site for a long-term view.

An example is presented below, for a new plant. In the real world, some equipment will be newer than others, so the remaining life versus standard lifetime will have to be assessed as well. The example below does not consider the important effect of inflation over time, which can be added depending on the country or premises used in the economic models.

The asset mapping approach provides a long-term view in terms of an industrial site sustainability capital needs.

The precision of this information will depend on how deep the discussions (and how engaged the site`s industrial, engineering and procurement professionals) will be in the exercise. Some companies keep a database for budgeting purposes, which can be used.

This method is much more precise than the previous ones: it does not rely on a biased risk analysis made for a few equipment or events. Considering that the industrial assets will require partial or full replacement over time, this approach also does not consider how much EBITDA the site generates or will generate in the short or long-run. As mentioned before, the equipment does not know if the product is paying off its operation, and it will fail anyway without maintenance or replacement.

If the company does not envision enough cash generation to run the business in a medium or long-term view, it should search alternatives (especially if the crisis is seen as a cyclical one), or, even shut down the site – the broader effect of this decision in the company should be evaluated. Reducing capex without considering the assets needs, while keep then running without respecting their replacement requirements overtime, is a commitment to operational downtime, bad cost and quality performance or even serious accidents, in a near future. And the need of Capex will still be there. Postponing will probably add an aggravation effect. This approach can prevent endless discussions about what is the usual or “fair” capex for each site. This decision should be made using a strategical lens: considering the capacity of that site to really generate cash in the long-run (to deserve the capex) and the asset`s requirements considering their lifetime.

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