What is Capital Expenditure?
Capex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in plant, property, equipment, and depreciation expense during a fiscal year.
Understanding Capital Expenditure
In simple words, it refers to the financial outlay for buying, maintaining, or improving the fixed assets base (such as plant, property, and equipment) of the company. The money spent is considered for the sole purpose of buying new fixed assets, repairing the existing fixed assets, or upgrading the existing capacity of the fixed assets. Capital expenditure is a major financial decision for a company, must be formally approved at an annual shareholders meetingShareholders MeetingShareholders Meeting means a meeting of the stockholders of the corporation wherein resolution are placed before the shareholders to discuss and approve the corporate matters and other matters required by the bylaws of the company. or a special meeting of the Board of Directors.
Capital expenditure examples includes:
- buying 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. and sometimes intangible assets
- repairing an existing asset to improve its useful life
- upgrading an existing asset to increase its performance
A CAPEX offers the potential to reap benefits in the future as a part of long-term strategic goals. However, the biggest challenge associated with the decision of capital expenditure is that it cannot be undone in the future without incurring losses given the huge initial outlay. As such, wrong capital investment can be detrimental to a company’s growth. Nevertheless, it has to be incurred either in the form of a new setup or up-gradation of the existing setup to ensure that the company is operating with state-of-the-art technology. It is to be noted that if the capital expenditure incurred during the year is higher than the depreciation expense during the year, it indicates a company’s growing asset base. Otherwise, it is a shrinking asset-based company.
Capital Expenditure Accounting
Going by the general rules of Capex accounting, if the acquired property’s useful life is longer than the taxable year, then the cost must be capitalizedCost Must Be CapitalizedCapitalization cost is an expense to acquire an asset that the company will use for their business; such costs are recorded in the company's balance sheet at the year-end. These costs are not deducted from the revenue but are depreciated or amortized over time.. This cost is not charged to the profit and loss statement at once in the taxable year but is spread over the useful life of the asset in the form of amortization and depreciation.
#1 – Effect on Balance Sheet
The entire capital expenditure cost is capitalized on the asset side of the balance sheet. It increases the non-current assetThe Non-current AssetNon-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. base of the entity, while at the same time reducing the cash balance of the entity.
#2 – Effect on Income Statement
The capital expenditure costs are amortized or depreciated through profit and loss statement over the useful life of the asset.
source: Ford SEC Filings
#3 – Effect on Cash Flow Statement
Since the reduction in the cash balance of the entity is reflected in the balance sheet as at the end of the taxable year, this financial outlay does get reflected in cash flow statement from investingCash Flow Statement From InvestingCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow. activities section as capital spending, purchases of property, plant, and equipment (PPE), acquisition expense, etc.
Shown below is the capital expenditure example of Walmart Inc. from its 2018 10-k SEC filings.
- From the above snippet of the cash flow statement, it can be clearly seen that Walmart spent $10,051 million to buy property and equipment in the financial year.
- Since the expenditure was towards buying the fixed assets and the amount is huge for it to be expensed in the income statement all at once, this expenditure could be classified as capital expenditure.
- More information about the exact nature could be found out if one digs into the notes of the company, which could be found in their financial filings.
- Many times, a pattern could be seen in such expenditures of the company. It could reflect that the company is expanding aggressively as per the strategic decision of the board of the company in order to cater to a larger market share.
Capex is Different from Other Expenses
Some industries are more capital-intensive, and some are less capital-intensive. The capital expenditures of an entity depending on the industry it operates in. Capital-intensive industries, like oil exploration and production, like telecommunication, like manufacturing, and utility industries, have the highest levels.
- The capital expenditures are different from operating expenses (also known as Opex) as the Opex or the revenue expenses are fully text-deductible in the same year in which the expenses occur.
- Also, these expenditure is a non-recurringNon-recurringNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off. strategic financial outlay that impacts the long-term asset base or something that could not be deducted in full in the year in which it was incurred and hence is amortized over the useful life of the capital asset.
- For example, buying a new car is a capital expenditure which could be amortized over its useful life (generally accepted as 5 years by the accounting rulesThe Accounting RulesAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. and industry norms). Though after 5 years the car could still be in working condition, its value could only be charged to profit and loss statement only during the useful life for the tax-deductible purpose.
How to use of Capex?
#1 – 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. to Capex is a very important ratio used by Financial Analysts. It is as follows:
If the ratio is greater than 1, it could mean that the company’s operations are generating cash, sufficient to fund its asset acquisitions. On the other hand, if the ratio is less than 1, it could mean that the company may need to borrow money to fund its purchase of capital assets.
#2 – Calculating FCFF
Also, CapEx is used in calculating the Free Cash Flow for the Firm (FCFF) as follows:
#3 – Calculating FCFE
Ans, CapEx is used in calculating the Free Cash Flow for the Equity HoldersFree Cash Flow For The Equity HoldersFCFE (Free Cash Flow to Equity) determines the remaining cash with the company's investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company's equity capital management (FCFE) as follows:
Below is the FCFE calculation of Alibaba.
Relevance and Use
- Capital expenditures refer to the strategic financial outlay of funds for the purchase, improvement, or maintenance of long-term assets to improve the efficiency or capacity of the company. Long-term assets are usually physical, fixed, and non-consumable assets like property, equipment, or infrastructure 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. and intangible assets such as software, patent, or license depending on the business of the company.
- CapEx is stated in the cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities. under the investing activities section as capital spending, purchases of property, plant, equipment (PPE) and acquisition expense, etc. The substantial effect of CapEx on the short-term and long-term financial standing of an organization warrants to making wise expenditure decisions of critical importance to the financial health of a company.
- Many companies try to maintain the levels of their historical capital expenditure to show investors that the managers of the company are investing effectively in the business, and there are ample opportunities for growth in their business instead of making an idle pile of cash sitting in their balance sheet.
- These expenditure decisions are very critical to an organization due to their substantial initial costs, irreversibility, and long-term effects. Therefore, budgetingBudgetingBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time. for capital expenditures ought to be carefully and efficiently planned and executed.
Capital Expenditure Video
This article has been a guide to what is Capital Expenditure (Capex) and its meaning? Here we discuss Capital Expenditure accounting along with examples and analysis. You may learn more about accounting from the following articles –