What is a Capital Expenditure (CAPEX)?
A capital expenditure (“CapEx” for short) is the payment with either cash or credit to purchase long term physical or fixed assets used in a business’s operations. The expenditures are capitalized (i.e., not expensed directly on a company’s income statement) on the balance sheet and are considered an investment by a company in expanding its business.
Capital expenditures (CapEx) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. CapEx is often used to undertake new projects or investments by a company. Making capital expenditures on fixed assets can include repairing a roof, purchasing a piece of equipment, or building a new factory. This type of financial outlay is made by companies to increase the scope of their operations or add some economic benefit to the operation.
CapEx is important for companies to grow and maintain their business by investing in new property, plant, equipment (PP&E), products, and technology. Financial analysts and investors pay close attention to a company’s capital expenditures, as they do not initially appear on the income statement but can have a significant impact on cash flow.
Сapital expenditures include the purchase of items such as new equipment, machinery, land, plant, buildings or warehouses, furniture and fixtures, business vehicles, software, or intangible assets such as a patent or license.
The expenditure amounts for an accounting period are disclosed in the cash flow statement. Capital expenditures normally have a substantial effect on the short-term and long-term financial standing of an organization. Therefore, making wise CapEx decisions is of critical importance to the financial health of a company. Many companies usually try to maintain the levels of their historical capital expenditure to show investors that the managers of the company are continuing to invest in the growth of the business.
Understanding Capital Expenditures (CapEx)
Although the expenditures are beneficial to a company, they often require a significant outlay of money. As a result, companies must budget properly to effectively generate the revenue needed to cover the cost of the capital expenditure.
Capital expenditures are often employed to improve operational efficiency, increase revenue in the long term, or make improvements to the existing assets of a company. Capital spending is different from other types of spending that focus on short-term operating expenses, such as overhead expenses or payments to suppliers and creditors.
Investors and analysts monitor a company’s capital expenditures very closely because it can indicate whether the executive management is investing in the long-term health of the company.
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 is 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) like office buildings, land, equipment), office infrastructure like computers, furniture, 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. 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 in reducing the 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 Formula
Capital expenditures are calculated using the property, plant & equipment (PP&E) costs and the current depreciation.
Capital Expenditure = Change in PP&E + Current Depreciation
The change in PP&E is calculated by subtracting the previous period’s property, plant & equipment costs from the current period’s amount. This data can be found on the balance sheet.
The current depreciation can be found on the company’s profit & loss statement.
Types of Capital Expenditures (CapEx)
The IRS categorizes types of capital expenses that businesses can capitalize: business startup costs, business assets, and improvements. These specific expenses may include:
- Intangible assets (patents, licenses, trademarks, etc.)
In short, any expenditures related to acquiring new assets such as those listed above or upgrading these assets is a type of capital expenditure. Below are some of the common types of capital expenditures, which can vary depending on the industry.
Buildings and Property
A purchase or upgrade to a building or property would be considered a capital purchase since the asset has a useful purpose for many years. Purchases of property, plant, and equipment are often facilitated using secured debt or a mortgage, for which the payments are made over many years.
Interest expenses associated with debt financing may be depreciated as well as the cost of the asset. However, costs incurred with an issue of stock would not qualify for depreciation.
Upgrades to Equipment
In the manufacturing industry and other industries, machinery used to produce goods may become obsolete or simply wear out. Upgrades to the equipment are often are needed. If these upgrades are higher than the capitalization limit that is in place, the costs should be depreciated over time. Similar to buildings or property, equipment upgrades are often financed. The cost of this financing may be depreciated as well.
Software expenditures are a significant cost for large companies. Costs to upgrade or purchase software are considered CapEx spending and can be depreciated.
Technology and computer equipment, including servers, laptops, desktop computers, and peripherals would be capital expenditures.
Companies often need a fleet of vehicles for distribution or to carry out services for customers, such as delivery companies. These vehicles are considered capital expenditures. However, the costs associated with leasing vehicles are treated as operational expenses.
Assets for capital expenditures don’t all need to be physical assets or tangible, but instead, can be intangible assets. If a company purchased a patent or a license, it could be considered a capital expenditure.
Importance of CAPEX
Capital Expenditures are amongst the most critical decisions for the company, as they have a long-term effect on the business. Their impact extends into the span of more than one year, and for some massive capital projects, the useful life can be much more.
It is crucial to understand that the current production capacity and product lines are the results of capital decisions in the past. Significant CAPEX is often very vital for the organization. Therefore before the company undertakes large capital projects, it needs a well defined long-term strategy in place.
Another reason why capital expenses are essential for the business lies with their high initial costs. Such projects can be costly, especially in some industries like production, oil, utilities, and others. While investments in equipment and facilities will most likely result in benefits in the long-run, they require significant initial funds.
Decisions on how much to invest in capital expenditures can often be extremely vital decisions made by an organization. They are important because of the following reasons:
1. Long-term Effects
The effect of capital expenditure decisions usually extends into the future. The range of current production or manufacturing activities is mainly a result of past capital expenditures. Similarly, the current decisions on capital expenditure will have a major influence on the future activities of the company.
Capital investment decisions are a driver of the direction of the organization. The long-term strategic goals, as well as the budgeting process of a company, need to be in place before authorization of capital expenditures.
Capital expenditures are often difficult to reverse without the company incurring losses. Most forms of capital equipment are customized to meet specific company requirements and needs. The market for used capital equipment is generally very poor.
3. High Initial Costs
Capital expenditures are characteristically very expensive, especially for companies in industries such as production, manufacturing, telecom, utilities, and oil exploration. Capital investments in physical assets like buildings, equipment, or property offer the potential of providing benefits in the long run but will need a huge monetary outlay initially, and much greater than regular operating outlays. Capital costs also tend to rise with advancing technology.
Capital expenditures have an initial increase in the asset accounts of an organization. However, once capital assets start being put in service, depreciation begins, and they decrease in value throughout their useful lives.
For an expense to be recognized as an asset and capitalized, there are specific requirements it must meet.
First, we must use the item for the main business activities, hold it for sale or rent, or use it for administrative purposes (like an office building). The useful life of the asset has to be over one year.
IAS 16 Property, Plant and Equipment stipulates that we can capitalize an expense only if it’s probable to a reasonable extent that economic benefits from the asset will flow to the business in the future. Another requirement is that we have to be able to measure the cost reliably. While IAS 16 establishes the requirements for tangible assets, intangible assets fall under IAS 38 Intangible Assets.
Initially, we recognize assets at their cost, which is the purchase price and any duties and non-refundable purchase taxes. It also includes any expenditures related directly to delivering the asset to the location where the company will use it and bringing it to the condition to operate as management intended.
We only capitalize subsequent expenditures on the asset if they either broaden its useful life or improve the benefit for the business. Costs related to repairs of the item, or regular maintenance as a result of normal wear and tear, do not cover the requirements. Therefore, such costs are expensed directly in the Income Statement.
Capital Expenditure vs. Operational Expenditure
Capital expenditures are related to growing and improving the assets of a business. They are considered long-term investments. Operational expenditures (OpEx), on the other hand, are expenditures related to the day-to-day operation of a business.
Here’s how they compare:
|Capital Expenditure (CapEx)||Operational Expenditure (OpEx)|
|Long-term investments in improving and acquiring new assets for a business||Shorter-term expenses related to the day-to-day operations of a business|
|Items are capitalized as an asset||Items are expensed|
|Assets that depreciate over time||Expenses that are accounted for in the current year’s accounting period|
|Examples include improving or buying assets such as property, a plant, and equipment (PP&E)||Examples include expenses such as rent, utilities, advertising, administration fees, etc.|
Here are a few ways to plan and control your CapEx budget:
Plan and structure:
Capex budgets require proper planning before implementation. Before commencing on a capital project, you need to ascertain the scope of the project, work out realistic deadlines, ensure review and approval of the project plan. The 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.
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 details:
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.