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.
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:
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:
- Locate the depreciation and amortization amounts on the income statement.
- Find out the current amount on a period property, plant, and equipment (PP&E) from the balance sheet.
- Locate the prior property, plant, and equipment amount on the balance sheet.
- Once these amounts are located on the income sheet, the below formula can be used for calculating net capital expenditure.
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 use the value of Capex to gauge the firm’s investment initiatives and their extent.
- The long-term profitability of the business is significantly influenced by Capex. Particularly in the manufacturing industry, the scale of operations is governed by the company’s past CapEx concentration. The current CapEx paves way for future operations.
- Capex is also used for calculating the free cash flow to equity ratio for a firm. Determining the free cash flow with respect to its equity can be calculated using capital expenditure value.
- Capital expenses cannot be reversed and may lead to business losses. Businesses need to plan and prepare a capital expenditure budget as per the specific requirements of the business. Such customized capital equipment and machinery do not have a future in the general capital market.
- Capital-intensive industries like oil exploration, production, telecom, etc. have to factor in the initial investment cost, which is significantly high. Investment in assets like PP&E generates long-term business profits. Technological advancements also result in an increase in capital costs.
- The asset account of business organizations is increased through capital expenditure. However, the capital assets begin to depreciate in value once they are used. Their value steadily depreciates over time.
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:
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.
