What is Capital Expenditure (CapEx)

A business idea is a seed for starting a business. Capital investment is required to gather goods and services for starting the business. Once a business is started, CapEx is the fuel that keeps the business going by procuring capital assets. Capital expenditure (CapEx) is the fund used by a business to purchase or improve or maintain long-term assets of the business in order to improve the capacity and efficiency of the business.

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Understanding Capital Expenditure (CapEx) Process

Capital expenditure is funds used by the business to procure, upgrade, and maintain assets required to run the business. Expanding business operations requires capital expenditure. Undertaking new projects or investments by a company is taken care of by the CapEx budget. Capital spending is undertaken to increase the scope of operations or increase the economic benefit to the operations.

CapEx also referred to as capital spending includes all the business expenses towards the purchase of new land, equipment, plants, warehouses or buildings, furniture or fixtures, software, business vehicles, or intangible assets like patents or licenses. Operational expenses (OpEx) on the other hand are the operating expenses that the company incurs for day-to-day operations. These are not included in capital expenditure. Capital expenditure examples include capital spent for property, plant, and equipment (PP&E) office buildings, land, equipment), office infrastructure like computers, furniture, and other machinery), and intangible assets like licenses, copyrights, and patents.

All purchases are not classified as CapEx, only when the expense exceeds the capitalization limit, it is classified as a capital expense. A capitalization limit is usually set by businesses in order to decide if a purchase can be classified as a fixed asset. Another way to classify purchases as capital expenditure is to consider the revenue-generating capacity of the asset or its contribution to reducing production costs. The procured asset must have a productive purpose and a useful life spanning more than one accounting period. In accounting lingo, the purchase is recorded as a capital asset rather than an expense, and costs incurred are recorded as depreciation and charged to the expense account.

Let us understand capital investment depreciation with an example. The purchase of machinery worth 60, 000 USD is recorded in the balance sheet as capital expenditure. As the machine starts aging, its value starts decreasing. The depreciation calculation is applied to the machinery and at the close of the accounting year the reduced value is shown as depreciation value in the financial statement.

Capital expenditure is undertaken to improve the operational efficiency of the business, increase long-term revenue, and improve existing assets. Capital expenditure is closely monitored by investors and analysts because of the long-term impact on businesses’ health.

Are capital expenditures tax deductible? Although not directly deductible, Capex can contribute to the indirect reduction of the company’s tax payable through the depreciation value of the fixed assets. The depreciation on fixed assets purchased via capital expenditure helps in reducing income taxes.

Capital expenditure is often confused with operational expenses. Capital expenditure is usually done with a long-term business goal in mind. Operating expenses on the other hand focus on the ongoing operational costs of running the business. The capital expense cannot be deducted from the company’s tax deductions in the same year as the expenses occur. Operational expenses are fully deducted from the company’s tax deductions for the same period as the expenses incurred.

In accounting, an asset is treated as capital expenditure when it is newly purchased or has a useful life that spans more than a financial year. Expenses towards maintaining the asset in an operable condition are considered as OpEx and are deducted fully in the same year as incurring the expense.

Difference between CapEx and Operational Expenses (OpEx)

Types of Capital Expenditure

The type of capital expenditure varies according to the industry and the type of purchase. The main types of capital expenditure are listed below:

Building and property

Investment in building and property for a business is classified as capital expenditure. This investment made to purchase or upgrade a building or property is considered a capital expense because it fulfills a useful purpose for a number of years. Capital investment in property, equipment, and plant is often carried out using a secured debt or mortgage. Completion of payment is done over many years. The interest expenses incurred due to the loan may be depreciated along with the cost of the asset. However, the costs incurred due to the issue of stock would not be considered depreciation.

Equipment purchases or upgrade

Purchase and upgrade of equipment are frequently undertaken by the manufacturing industry. Old machinery used for producing goods may wear out or become obsolete, in which case they need to be replaced or upgraded. If the upgrade costs exceed the capitalization limit, then the costs need to be depreciated over time. In some cases, new machinery may be required for expanding the business operations, this is also included in the capital expenses.

Software Upgrade

Large organizations need to spend significant amounts on buying or upgrading software. Expenses in upgrading or buying new software are classified as CapEx and can be depreciated.

Purchase of Computer Equipment

Purchasing technology and computer hardware like desktops, laptops, and peripherals are classified as capital expenditures.

Vehicles

Businesses require vehicles to transport their goods and services to their customers. Vehicles used for carrying out the business are considered to be capital expenses. In cases where vehicles are not bought but taken on lease, the costs are classified as operational expenses.

Intangible assets

Business assets like licenses, patents, and copyrights are considered intangible assets. The purchase of a patent or a license is considered a capital expenditure.

Capex involves a significantly large amount of capital, which requires the business to use debt. Long-term debt costs such as interest expenses require companies to generate enough revenue to service the debt. Too much Capex or poorly planned and executed expenses can put the company into financial trouble. Certain industries that are more Capex-driven than others must make calculative buying decisions.

Calculation of CapEx

What is the Capex or capital expenditure formula? CapEx is usually included in the cash flow section of the business’s financial statements. According to Capex’s definition, it is the money invested by the company in procuring, maintaining, or upgrading the company’s assets. To calculate capital expenditure, we can either use the capital spending formula or it can be derived from the income statement and balance sheet of the business. With access to the company’s cash flow statement, the value of capital expenditure can be found in the investing cash flow section.

When the cash flow statement cannot be accessed, the net CapEx can be calculated when the depreciation is broken out on the income statement.

Here is a stepwise calculation of capital expenditure:

Capture

The logic behind the formula is that the current PP&E is equal to the prior PP&E amount minus the depreciation. It should be borne in mind that the formula is to find the net capital spending. Any dispositions in the current PP&E will result in a lower CapEx value when calculated using the above formula.

The above Capex formula is very useful for the financial modeling of businesses that have complex financial statements. Companies that have elaborate capital asset schedules could use this formula for calculating their capital expenditure.

The Usefulness of Calculating CapEx in Business Analysis

The main purpose of calculating capital expenses is to analyze the business’s investment in fixed assets. The value of Capex is used in several ratios that form the basis for investment analysis. The cash flow to capital expenditure ratio throws light on the company’s ability to acquire long-term assets using free cash flow. When businesses go through large and small capital expenditures, the value of this ratio varies significantly. When the value of this ratio is greater than 1, it implies that business operations are able to generate the cash required to acquire business assets. A lower value of the ratio implies a cash flow crunch. This ratio can be used for comparing the performance of businesses belonging to the same industry.

Another useful business accounting value that can be derived using CapEx is free cash flow to equity (FCFE). The FCFE provides information on the amount of cash available for equity shareholders. Capex and FCFE are inversely related, the greater the value of Capex, the lower the FCFE value.

Significance of Capital Expenditure for a Business

Capital expenditure is an important expense for companies looking to maintain existing property and operations or upgrade business operations by investing in technology and other assets. What can CapEx tell you about the business? Analysis of capital expenses reveals how much the business is investing in new and existing assets for running and upgrading the business.

Capital-intensive industries like oil and exploration, telecommunication, production, utility, and manufacturing industries have the highest Capex levels.

Here is how Capex provides insights into business performance:

Financial analysts must compare the Capex of companies belonging to the same industry for a fair comparison.

Effective CapEx Budgeting Processes

Businesses need to have a clear CAPEX policy in place to avoid losses and mishandling of money. Large-scale capital projects that involve huge capital expenses can easily get out of control and result in business losses if not handled well. A clearly defined and planned capital expenditure budget ensures that capital expenses are handled efficiently. The right project management tools can provide an effective capital spending plan and help in expenditure control.

Here are a few ways to plan and control your CapEx budget:

Plan and structure

Capex budgets require proper planning before implementation. Before commencing a capital project, you need to ascertain the scope of the project, work out realistic deadlines, and ensure review and approval of the project plan. Capital budgeting must consider resource requirements like manpower, raw materials, services, and financial requirements. Including more details in the budget plan helps create a more accurate Capex budget.

Long-term vision

Capex spending is usually done having long-term business goals in mind. At the start of the Capex project, you need to decide on whether you will purchase the asset with debt or save funds for the purchase. Saving up for the purchase implies that there would be a wait time before making the capital purchase. Buying the asset on debt increases the debt for the business and decreases the borrowing limit of the business for future purchases. The buying decision must be taken having long-term business goals in mind.

Gather accurate data

Capex budgets must be based on accurate financial data. A realistic budget and valuable reports can be built on reliable and accurate financial data.

The optimal level of detail

A CAPEX budget should focus optimally on details; focusing on too much or too less details is not favorable for a Capex budget. The right optimal balance in the data needs to be found for creating the Capex budget.

Clear Capex policies

Having clear CAPEX policies that govern the creation of a budget help standardize the process across departments and locations.

Conclusion

Businesses need to have a clear CAPEX policy in place to avoid losses and mishandling of money. Large-scale capital projects that involve huge capital expenses can easily get out of control and result in business losses if not handled well. A clearly defined and planned capital expenditure budget ensures that capital expenses are handled efficiently. The right project management tools can provide an effective capital spending plan and help in expenditure control.

The optimal level of detail

A CAPEX budget should focus optimally on details; focusing on too much or too less details is not favorable for a Capex budget. The right optimal balance in the data needs to be found for creating the Capex budget.

Clear Capex policies

Having clear CAPEX policies that govern the creation of a budget help standardize the process across departments and locations.

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