What is Capital Expenditure (Capex)?
Capital expenditure (CapEx) of a business is the total capital spent on buying, maintaining, and upgrading fixed assets. This includes both tangible and intangible assets like machinery, equipment, manufacturing plant, land, buildings, transportation, technology, patents, and licenses.
Capex is determined by adding the net increase in manufacturing plants, property, equipment, and depreciation expenses within a fiscal year. Businesses rely on capital assets on a daily basis. Therefore, investing in them is crucial for the functioning and growth of the firm. Also, all these expenditures affect the balance sheet.
Table of contents
- What is Capital Expenditure (Capex)?
- Capital Expenditure Explained
- Types of Capital Expenditure
- Capital Expenditure Accounting
- CapEx Formula
- How to Calculate Capital Expenditure?
- Example of Capital Expenditure
- Difference Between Capital Expenditure and Revenue Expenditures
- Relevance and Use
- Frequently Asked Questions (FAQs)
- Capital Expenditure Video
- Recommended Articles
- Capital expenditure (CapEx) is the strategic investment of funds in the purchase, improvement, and maintenance of long-term assets. This is done to enhance the efficiency of business operations.
- Expenses on assets are considered CapEx only if the assets can be used for more than a year.
- Capex is calculated by subtracting an aggregate of the previous period’s property, plant, and equipment from the current total. Then, the residual amount is added to the depreciation charges for the current period. The depreciation is charged on fixed assets and includes amortization costs.
Capital Expenditure Explained
CapEx is simply the money a company pours into the buying, upgrading, and maintaining of long-term assets. These investment decisions are critical to an organization due to hefty initial costs, irreversibility, and long-term effects. Some industries are more capital-intensiveCapital-intensiveCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining. than others. Therefore, the CapEx of an entity depends on the type of industry. For instance, oil exploration and production have the highest CapEx levels. Similarly, telecommunication, manufacturing, and utility industries also require substantial investments.
Capital expenditure is a significant financial decision. It must be formally approved at an annual shareholders’ meeting or a board of directorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. meeting. To evaluate long-term investments and related cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. , firms take a closer look at CapEx. In addition, investors, shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares., lenders, and creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. also track the number of funds allocated to fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples..
Types of Capital Expenditure
CapEx is classified as follows.
#1 – CapEx on Tangible Assets
These are usually the physical, fixed, and non-consumable assets that have a useful life of more than one accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.. It includes the following:
- Investment in land, property, or building along with its maintenance, renovation, and debt repayment.
- Acquisition of manufacturing plant, machinery, and equipment along with repairs, upgrades, and depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. charges.
- Vehicle purchase for delivery and distribution of goods is another capital expenditure that involves maintenance, repair, and depreciation charges.
- Purchase and installation of computers, laptops, and peripheral devices along with maintenance costs.
#2 – CapEx on Intangible Assets
The value of cost incurred on the non-physical assets is realized in more than one fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th September. These are also considered CapEx. It includes the following:
- Purchase and upgradation of software,
- Getting patents and copyrights for technology, products, and services,
- GoodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price. paid by a company while taking over another firm,
- And license registration charges.
Capital Expenditure Accounting
If the acquired property’s useful life is longer than the taxable year, then the cost must be capitalized. This cost is not charged to the profit and loss statement at once. Rather this cost is spread over an asset’s useful lifeUseful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets. in the form of amortization and depreciation.
Given below is an example from Ford Motors that represents how CapEx affects the financial statements:
#1 – Effect on Balance Sheet
The entire capital expenditure cost is capitalized on the asset side of the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.. Thus, it increases the non-current assetsNon-current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark. of the entity. Simultaneously, CapEx also reduces the cash balance.
The highlighted items in the asset section denote the capital expenditure.
#2 – Effect on Income Statement
The capital expenditure costs are amortized or depreciated through profit and loss statements over the asset’s useful life.
#3 – Effect on Cash Flow Statement
The reduction in the cash balance of an entity is reflected in the balance sheet at the end of the taxable year. Therefore, this financial outlay does reflect in the cash flow statement. In addition, it is mentioned in the investing activities section that includes the purchase of property, plant, and equipmentProperty, Plant, And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. .
The capital expenditure can be calculated with the help of the following formula:
- ∆P, P&E is the change in property, plant, and equipment,
- The depreciation accounts for the current accounting period, including the amortization of intangible assets,
- P, P&E of current period comprises the total value of the property, plant, and equipment for the current accounting period; and
- P, P&E of the prior period comprises the total value of the property, plant, and equipment during the previous accounting period.
How to Calculate Capital Expenditure?
CapEx is calculatedCapEx Is CalculatedCapital Expenditure is the total amount that a Company spends to buy & upgrade its fixed assets like PP&E (Property, Plant, Equipment), technology, & vehicles etc. You can calculate it by adding the net change in PP&E value over a given period to the depreciation expense for the same year. using the following steps.
- Calculate the increased amount of property, plant, and equipment by deducting the previous period’s total fixed assets from the current period’s aggregate.
- Using the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., find the total depreciation charged on fixed assets for the current period. Also, locate the amortization expenseAmortization ExpenseAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset. for intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. .
- Now, add P, P & E changes to the depreciation expense of the current period to evaluate CapEx.
Example of Capital Expenditure
Consider the following CapEx example to understand practical applications better.
Shown below is the capital expenditure example of Walmart Inc. from its 2018 10-k SEC filingsSEC FilingsSEC filings are formal documents submitted to the Securities and Exchange Commission in the United States that contain financial information about the company as well as any other relevant information about recent or upcoming activities..
- The above cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business. shows Walmart spending $10,051 million to buy property and equipment. This was the expenditure for one financial year.
- Walmart spent a lot for acquiring fixed assets. Therefore, in the income statement, it cannot be expensed all at once. Thus, this expenditure can be classified as a capital expenditure.
- More information about the exact nature can be found from the company’s notes, located in financial filings.
- Often, a pattern is seen in a company’s spending. This could potentially reflect aggressive expansion.
Difference Between Capital Expenditure and Revenue Expenditures
CapEx focuses on long-term benefits. In contrast, the revenue expenditureRevenue ExpenditureRevenue expenditure refers to those costs incurred during regular business operations by the organization while availing its benefits in the same period. Such operating expenses include rent, utility expenses, salary, insurance expenses, etc. or OpEx is the daily operations cost. This cost facilities conversion of inventory into finished goods.
For Capital expenditure, physical assets can be depreciated throughout their useful life, and non-physical assets can be amortized. However, for revenue expenditure, the operating expenses have to be accounted for in the same accounting year.
Examples of revenue expenditure include rent, wages, salary, electricity bills, freight, and commission. Most capital expenditures are leveraged. In contrast, the operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. under revenue expenditure come from the company’s working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)".
Relevance and Use
The application and relevance of CapEx in the business world are as follows.
- Computing CFO to CapEx Ratio: Cash Flow from OperationsCash Flow From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. divided by CapEx is a vital ratio used by financial analysts. They ascertain if the cash generated from business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation. is enough to fund capital expenditures. A ratio higher than one is considered feasible.
- Calculating Free Cash Flow for Firm (FCFF): Capital expenditure is also used in ascertaining the value of FCFFFCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.. The formula is as follows:
Free Cash Flow for Firm = EBIT (1 – Tax Rate) + Depreciation – Change in Net Working Capital – CapEx.
- Determining Free Cash Flow for Equity Holders (FCFE): The CapEx figure is put into the following formula.
Free Cash Flow for Equity Holders = Net Income + Depreciation – Change in Net Working Capital – CapEx + New Debt Raised – Debt Repayment.
- Aid Investment Decision-Making: The significant effect of CapEx on the short-term and long-term financial standing of an organization warrants making wise expenditure decisions.
- Attract Investors: Many companies maintain historical capital expenditure records to show the investors that the managers are investing effectively.
- Facilitate Capital Budgeting: All investments on capital items are executed after careful planning. These investments significantly impact cash flow. For analysis, companies take a closer look at previous years’ CapEx and the availability of funds.
Frequently Asked Questions (FAQs)
The formula for computing the capital expenditure is as follows:
Here ∆P, P&E is the change in the value of property, plant, and equipment between the current period and the previous period. Also, the depreciation amount is charged only for the current accounting period.
CapEx is the amount used to purchase, enhance, or maintain long-term business assets during a specific period. On the other hand, the operating expense (OpEx) is the recurring cost incurred on a daily basis.
The capital expenditure budget is a strategic layout for investing in long-term assets. Based on this layout, the company will invest in the coming fiscal year. This layout is prepared every year. Also, the CapEx budget includes CapEx limits and purchase timings of each asset.
Capital Expenditure Video
This article has been a guide to what is Capital Expenditure and its Meaning. Here we explain Capex accounting, its types, and its uses. You may learn more about accounting from the following articles –