Capital Expenditures, or CAPEX for short, are cash or credit payments to acquire goods or services that we capitalize in balance sheet assets. From the company’s perspective, we consider those to be an investment. Here we include all expenses that are not shown on the Income Statement and do not affect profit and loss for the current period.
CAPEX is an important concept, as this is the way for the business to support and expand its operating capacity by investing in property, plant and equipment, and technology.
As financial analysts, we pay close attention to Capital Expenditures, as they are not part of the Income Statement, but may have a significant impact on the Cash Flow Statement.
What is CAPEX?
The industry in which the company operates has a significant impact on the nature of the Capital Expenditures. In most cases and for most companies, CAPEX usually includes:
- Machinery and equipment;
- Buildings and improvements;
- Hardware and software purchases;
- Transport vehicles.
Such investments can either be in new assets or existing ones. Once the purchase is recognized, we use depreciation and amortization to spread the acquiring costs over its useful life.
There are two forms of CAPEX. One is expenditures to maintain the level of operations, and the other is to enable the future growth of the business. These can also be two types – tangible, like computers and buildings, and intangible, like software and intellectual property.
It is important to remember that regular maintenance of assets, as well as repairs to bring them back to an operational level, are not recognized as long-term assets, and can therefore not be capitalized. Instead, we expense these directly through the Income Statement.
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.
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.
In most jurisdictions, tax authorities have a prescribed asset recognition threshold, above which we consider an expenditure to be a capital investment. Most companies assume the same as their respective tax authority, to avoid keeping both an accounting and a tax fixed asset registers. However, businesses can specify any threshold they want for accounting purposes, as long as it is reasonable for the company.
Companies can also combine low-cost assets into pools to pass the capitalization threshold. For this, said assets have to meet all the other recognition criteria and also be homogenous in a certain sense.
Let’s say we are running a mobile car repair service. We have our servicing vans, which we have capitalized and are now presenting on the Balance Sheet. But we also have an extensive set of instruments in each van, so our mechanics can perform their job correctly. All these instruments have a low cost compared to the capitalization threshold. But since we use them in the main business activity, and expect them to last about two years, before we replace the whole set, we can pool them together and recognize pool assets for the instrument sets in each van.
Capital Expenditures vs. Operating Expenditures
Some rules govern which items can be capitalized and which we have to expense in the Income Statement.
Generally speaking, this depends on how long the company will receive benefits. If we plan to use it for less than one financial year, the item is expensed directly in the Income Statement. On the other hand, if we expect to reap benefits for a more extended period, we can capitalize the expenditure in the Balance Sheet. As an example, we will treat printer paper as an operating expense (OPEX), as we use it in our daily operations. At the same time, we will consider the purchase of an office building as a Capital Expenditure (CAPEX).
In finance and accounting, Capital Expenditures and Operating Expenses are two types of business expenses. CAPEX usually refers to significant investment purchases to use for a more extended period, while OPEX comprises of the daily costs to support the operational needs of the business.
CAPEX in the Financial Statements
We present the CAPEX for the financial year in the Cash Flow Statement of the company, in the section for investing activities. We categorize this spending as an investment, so it has no direct reflection on the Income Statement. Capital Expenditures go through cash flows and end up in the long-term assets on the firm’s Balance Sheet.
Over time, depreciation and amortization expenses reduce the asset value.
To calculate the Capital Expenditures from the Financial Statements of the business, we can use the following formula:
- PPE CB is the closing balance of property, plant and equipment for the year;
- PPE OB is the opening balance of property, plant and equipment for the year;
- DA is the amount of Depreciation and Amortization expenses shown in the Income Statement.
When we depreciate (or amortize) an asset, there are various methods that we can apply. However, the most popular one is the straight-line depreciation method. When we employ this technique, we spread the total acquisition value of the asset equally over the number of periods in its useful life. That way, the accumulated depreciation at the end of the asset’s life will equal the Net CAPEX.
A business that consistently shows a higher Capital Expenditure than expenses for depreciation and amortization has a growing asset base.
Capital Expenditures in Financial Modeling
In valuation and financial modeling, we often prepare Discounted Cash Flows (DCF) models to derive the Net Present Value (NPV) of the business operations of the company.
The most popular method to achieve that is calculating the Free Cash Flow to the Firm (FCFF) and then discount it back with the Weighted Average Cost of Capital (WACC) as a discount factor.
This is where CAPEX becomes useful, as FCFF equals the cash flows from operations, decreased with the Capital Expenditures.
Issues with CAPEX
One of the main issues with Capital Expenditures is identifying and evaluating their cost, which can become daunting and time-consuming in complex projects. There are also secondary effects for which we cannot assign value. For example, when we upgrade our sales delivery vehicles with newer ones, our sales reps will be more likely to remain in the company. The capital investment will increase their loyalty, as they will see that management cares for them and want them to have a better and more safe experience while driving. However, it’s impossible to evaluate the monetary value of the said increase in loyalty.
Whenever the business undertakes large capital investments, this usually follows the long-term strategic plans of the company. Managers align such projects with the forecasts and development plans of the business. Since such estimates of the future performance can sometimes be way off, or even wrong, the potential future benefits from capital investment gain some inherent uncertainty and unpredictability.
Preparing a Capital Budget
Large investment projects often tend to get out of control, which can become a massive loss-generating exercise for the company. We need to pay attention to project planning and management, as well as employ the right tools and resources to secure a successful outcome.
Proper planning is essential for success. We need to define the right scope for the project and set realistic deadlines. The more detail we have in our plan, the more accurate our budget will be.
The source of funding for the project is another central point to consider. We need to evaluate the long-term effects of using either the company’s available funds or securing debt for capital investment. If we use debt, we may put stress on the business with repayments and interest for years to come, while using the company’s funds might require waiting to put the money aside.
It is also of utmost importance to ensure we are preparing our plan and budget with accurate data and reliable information. When designing the capital budget, a challenge you will face is finding the right level of detail for it. Too much will make the budgeting and subsequent tracking processes very cumbersome and resource-heavy, which will harm the business. On the other hand, too little detail will most likely result in flawed analysis and the inability to make informed decisions during the project.
Capital Expenditures are vital to any business. They keep the operating capacity and provide opportunities for growth and expansion of the company.
Decisions related to CAPEX are very critical to the company. They have a substantial initial cost, impact the future of the business, and come with a certain level of unpredictability.
The main difference between Capital Expenditures and Operating Expenses is that CAPEX increases your asset base, while OPEX decreases your profit.
It is essential to take the time to properly plan and budget any capital investments so that they don’t turn into a loss-generating exercise for the company.
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Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
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The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained in the result of using the information presented in the publication.