What it means
Capital goods are goods bought in order to produce other goods and services, as opposed to consumer goods bought for use. The sector therefore includes machine tool makers, lift manufacturers, turbine builders, aircraft component suppliers and heavy construction equipment firms.
The sector matters as an economic signal as much as an investment category. Orders for new equipment reflect what businesses believe about the next few years, so a sharp fall in capital goods orders usually arrives before a slowdown in the wider economy.
In practice the sector is tracked through order books rather than sales alone. Analysts watch new orders, the backlog of unfilled orders and the book-to-bill ratio, which compares orders received with revenue billed in the same period.
Businesses selling into the sector plan around its long cycles. Contracts are large and lumpy, delivery and installation can take years, and a single postponed project can move a quarter's results, which is why these companies hold large order backlogs and report them to investors.
One nuance is that the label differs between classification systems. Some index providers fold capital goods into a broader industrials group, while national statistics often report core capital goods orders, a measure that strips out aircraft and defence to reduce the distortion from a handful of huge contracts.
For a manager outside the sector the practical use is as a timing tool. If a business sells services to equipment makers, the order figures published by its customers give several quarters of warning about its own pipeline, which is long enough to adjust hiring and stock levels calmly.
In practice
Real-world examples.
Example
A pump manufacturer reports a book-to-bill ratio of 1.3 and a record backlog, so it hires 60 production staff and adds a second shift, confident that revenue is already contracted rather than hoped for.
Example
A commercial bank's industry team uses capital goods orders as an early indicator for its lending book. When orders fall for two consecutive quarters, the team tightens credit criteria for equipment finance before loan losses appear.
Example
A government considering an investment allowance for plant and machinery models the effect on the capital goods sector first, because the allowance works by changing the price of exactly the equipment this sector sells.
Formula
Calculation
A standard measure for the sector is the book-to-bill ratio: Book-to-Bill Ratio = New Orders Received / Revenue Billed in the Same Period. Suppose a capital equipment maker takes new orders of $540,000,000 in a quarter and bills revenue of $450,000,000. The ratio is $540,000,000 / $450,000,000 = 1.2, meaning the order book took in 20% more work than it consumed, so the backlog grew by $540,000,000 - $450,000,000 = $90,000,000 during the quarter. A ratio below 1.0, for example orders of $380,000,000 against billings of $450,000,000, gives 0.84 and a backlog shrinking by $70,000,000, which is an early warning of weaker revenue two or three quarters later.Case study
Seen in the real world.
Virelo Industrial is an invented, illustrative maker of conveyor and materials handling systems. In a fictional strong year it bills $450,000,000 of revenue, takes $585,000,000 of new orders for a book-to-bill ratio of 1.3, and ends the year with a backlog of $610,000,000.
Encouraged by the backlog, in this illustrative story Virelo commits $60,000,000 to a new assembly plant. The following year its customers, mostly warehouse and mining operators, postpone expansion because their own demand weakens. Orders fall to $300,000,000 against billings of $480,000,000, a book-to-bill ratio of 0.63, and the backlog drops to $430,000,000.
Revenue holds up for a further year because the backlog is worked through, which hides the problem from anyone watching only the sales line. The illustrative lesson is that in the capital goods sector the order book, not revenue, is the leading indicator, and the new plant should have been tested against a weak order scenario before it was approved.
Watch out
Common mistakes.
- Judging a capital goods company on current revenue, when that revenue reflects orders won one or two years earlier and says little about the future.
- Treating the sector as a single block, when aerospace, construction equipment and electrical equipment run on quite different cycles.
- Reading one quarter of orders as a trend, because a single large contract can swing the figure sharply in either direction.
Questions
People also ask.
What is the difference between capital goods and consumer goods?
Capital goods are bought by businesses to produce other goods and services, while consumer goods are bought by households for their own use.
Why is the sector described as cyclical?
Because equipment purchases can be postponed when confidence falls, so orders drop much further than consumer spending in a downturn and recover more sharply afterwards.
Is core capital goods orders a better measure?
It is usually steadier, because excluding aircraft and defence removes the largest and least regular contracts from the figure.
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