Whether you are a part of the finance department or not, a foundational understanding of key finance metrics such as revenue, CapEx, profit, cash flow, and ROI (Return on Investment) is imperative for interpreting financial reports, budgets, and forecasts.
CapEx in particular is crucial for a company's growth, and this is a term we'll look to explore further in this blog. We’ll uncover answers to what CapEx is, what are the types, examples and its importance. From calculating to managing it, we will dissect all the essential aspects you need to know to empower you with the insights for making informed financial decisions.
What is CapEx?
Capital expenditure, or CapEx, refers to funds invested by a company to acquire or upgrade fixed, non-consumable assets such as infrastructure and technology. Recorded under property, plant, and equipment (PP&E) on the balance sheet, these assets have a longer lifespan, providing benefits to the company beyond a single fiscal year. These are one-time investments made to maintain and enhance current operational levels or to facilitate the growth of the company.
For example, money spent on purchasing new machinery is considered CapEx as it is significant one-time investment. In contrast, repair and maintenance expenses for existing equipment are not classified as capital expenditures. Instead, these costs are recorded in the company's income statement as repair and operating expenditures, or OpEx.
CapEx depreciation
Assets under capital expenditure are subject to depreciation, reflecting decrease in their value over time due to wear and tear. The depreciation period, as recorded on financial statements, represents an asset’s useful life. It starts as soon as the asset is put to use and continues until its predicted useful life, determined by various factors such as the nature of the asset and industry standards. It is important to note that the useful life is an estimate, and the asset might remain functional beyond that timeframe.
CapEx investments are not entirely tax deductible in the spending year, instead, the asset’s value is deducted over the course of its useful life. The asset's cost divided by its anticipated useful life establishes the annual depreciation deduction a business can claim. To better understand consider a company buys a delivery van with a useful life of 5 years. The van will gradually recover its value over the course of five years.
Different types of CapEx
Based on spending and its immediate intent for the business, CapEx can be classified as follows:
Acquisitions
Often intended for the direct expansion of the company, these expenses are related to acquiring new fixed assets, such as land or patents. It also includes the acquisition of a business and the launch of a subsidiary.
Upgrades
This includes spendings on upgrading or enhancing the efficiency of existing assets, such as equipment or a computer network, to boost their capacity or functionality. This may include adoption of new technology and modern solutions into the business.
Renovations
These expenses encompass spending on old or obsolete assets to make them functional in ways that add long-term value to the business. Repairs and maintenance are not considered a capital expenditure and are written off as a business expense the year they're paid out.
Adaptation
This includes expenses incurred to modify an existing asset for a completely new use that will benefit the business in the long run.
Environmental
It encompasses spending aimed at sustainability, compliance with environmental regulations, or reducing the environmental impact of the business.
Training and development
These include investments in employees and their training, skill development, and education to enhance the human capital within the organisation.
Research and development
These are capital expenditures directed towards developing new products, technologies, intellectual property, and processes.
What falls under CapEx
Collectively known as fixed assets, examples of capital expenditures can be classified into two main categories, tangible, and intangible assets.
Tangible assets
Tangible assets are those with a physical presence. They can be seen or felt and represent long-term physical investments that aren’t easily converted into cash. Capital expenditure examples that fall under tangible assets include:
- Any form of real estate such as land, new office premises, or manufacturing facilities.
- New machinery, equipment, and vehicles used for the company’s operation.
- IT infrastructure constituting computers and other hardware.
- Office furniture such as chairs and desks.
Intangible assets
Intangible assets are those that lack a physical form but still hold significance for the business. Capital expenditure examples that fall under intangible assets include:
- Intellectual Property comprising patents, trademarks, copyrights, and trade secrets.
- Licenses of products and services whose value extends beyond a single year.
- Investments in development or acquisition of software.
- Premium paid for acquiring another business, extending beyond tangible assets and represents the intangible value of the acquired company.
Positive vs negative CapEx
Capital expenditures provide insight into a company's commitment to growth. Understanding the implications of negative and positive CapEx amounts is crucial for analysts and investors.
As the company spends capital to be invested in resources to drive future growth, it is reflected as a negative CapEx entry on the cash flow statement (also referred to as capital outlays). Despite the negative cash flow, such investments often signal major projects, technological upgrades, and overall optimism from company management, portraying a healthy outlook for potential future expansion.
On the contrary, a positive CapEx entry on the balance sheet indicates cash inflow. While positive CapEx could result from divesting capital assets, it's not always negative for the company. For instance, the company might be selling old machinery that is no longer in use. However, in the long run, such divestitures might raise concerns. Despite yielding immediate financial gains, they could signal management’s lack of confidence in the business's future, potential hindrance to growth, or indicate insufficient spending on current operations.
Calculating CapEx
Calculating CapEx is a straightforward process, involving referencing a balance sheet or the cash flow statement of the company for a specific period. The calculation entails subtracting the current period's property, plant, and equipment balance from the prior period's PP&E balance and then adding the depreciation expense of the current year. This formula considers both new asset acquisitions and upgrades to existing assets.
CapEx formula
The basic formula for CapEx calculation is:
CapEx = PP&E (current period) – PP&E (prior period) + Depreciation (current period)
The formula for a balance sheet and/or income statement:
Total CapEx = Net increase in PP&E (from the previous year to the current year) + Depreciation for the current year
The formula for a cash flow statement is:
Net CapEx = Cash outflow (on the purchase of fixed assets) – Cash inflow (on sale of fixed assets)
CapEx vs OpEx
Both CapEx and OpEx (operating expenditures) are vital business expenditures, however, they differ in the impact they have on the business’s financial health and strategic growth. It is important to understand their differences to make well-informed financial decisions aligned with the organisation's overarching objectives.
CapEx are upfront investments that yield long-term benefits. They are non-tax-deductible and are reported on the balance sheet. On the contrary, OpEx are short-term ongoing expenses such as rent, utilities, and office supplies which are necessary for the day-to-day operations of the business. OpEx items are reported on the income statement and can be deducted from taxes for the year they are incurred.
The role of technology in managing CapEx
Effective management of capital expenditure is essential for businesses to maintain competitiveness, financial stability, and sustainable growth. Embracing technology in the finance industry is imperative for streamlining management processes, enhancing effectiveness, and ensuring adaptability in the face of changing market trends.
Given the significant financial commitment associated with CapEx, strategic allocation of these funds is crucial. Careful evaluation of project proposals, risk assessment, and prioritisation is necessary to maximise ROI and ensure financial stability. Implementing a financial management software not only streamlines these processes but also empowers your business with predictive analytics.
High capital expenditures can be viewed as either good or bad, depending on the company’s performance, strategy, and industry standards. While they often signify ambitions for expansion, they may also pose potential financial strain, especially in situations like inflated market conditions. In such cases, reducing capital expenditure becomes crucial to optimise costs, improve efficiency, and maintain financial flexibility. Cloud adoption can be a strategic solution to tackle high inflation market conditions.
Cloud-based technologies can facilitate agility, collaboration, automated approval workflows, and real-time visibility into expenditure (which then enables effective cost reduction strategies).
With the aid of modern technology, it is possible for businesses to continuously monitor CapEx spending and track expenses to stay within budget limits and make timely adjustments as needed. It also enables tracking of project performance, providing insights that contribute to maintaining a healthy balance sheet.
Advanced Financials: Helping you keep on top of CapEx
CapEx plays a significant role in shaping the financial health and long-term value creation of a company, and, at Advanced, we are here to assist you in managing it. Our Cloud-based financial management software, Advanced Financials, empowers your finance team to effectively handle your business’s capital expenditures.
Advanced Financials streamlines financial processes, automates manual tasks, and provides real-time insights into all financial activity, all consolidated in one place. With visibility into expenditure, you can effortlessly monitor CapEx spending and maintain budgets.
By offering valuable data insights, an easy interface, and built-in customisable reports, Advanced Financials facilitates strategic decision-making related to capital expenditures. It stands as an ally in your financial management journey, supporting growth and stability of your company.