Capital expenditures: Definition, Types, Importance and Formula
Capital expenditures, or CapEx, are purchases that are made by the company to preserve or rebuild long-term assets for the efficiency of the company. Property, equipment, and infrastructure are considered long-term assets that are tangible and non-consumable. These physical assets are considered productive even for more than another accounting cycle. The accounting cycle refers to the years, months, or weeks of accounting records that are included in the cash flow statement to be analyzed together with the expenditure amounts. Purchasing of new land, plant, equipment, machinery, building, vehicle, furniture, and fixtures are all capital expenses or CapEx. Capital expenditures still cover intangible assets such as software, licenses, and patents. The funds are not only intended for buying new assets but also to maintain and improve the condition of current assets. The long-term and short-term financial state of an organization has a substantial relation to capital expenditures. Thus, making wise decisions with CapEx plays a critical role in the company’s financial health. To maintain the level of the capital expenditure history, the company typically shows investors that managers are continually investing for the business’ growth.
Adding and improving the production facilities and boosting its operational efficiency, which is based on its capital expenditures, leads to the creation of assets and the generation of economic revenue in the long run. Labor participation, stock in the economy, and future production will rise due to the increase in capacity. Loan repayment is considered a capital expenditure; it reduces the liability together with the creation of other assets. Based on the previous accounting period, the capital expenditures can be computed by including the present depreciation value along with the changes in the plant, property, and equipment that reflects in the cash flow statement.
What is Capital Expenditures?
Capital expenditures are budgets used to buy sustain or modify assets such as buildings equipment office furnishing and other material assets. Capital expenditures are not only intended to buy the new asset, but also for maintenance, and improvements may include reparations of equipment and warehouse remodeling. Capital expenditures also called “CapEx” this outlay are often used to acquire and keep in good working order the means of production and arrangement of the organization's goods and services.
What are the different types of Capital Expenditures?
Many types of assets can contribute long-term value to a company. Listed below are the different types of capital expenditures that can be considered.
- Patents: It is a type of intangible asset that is considered a long-term value of a company that was created as an original idea from the development.
- Buildings: The building is considered an infrastructure asset of a business used for the utilization of office space or a warehouse for the production of goods and services that support generating income for the business.
- Furniture: It is an essential tool for an office, either office staff or customers and clients use. It is a company's physical asset that is part of company expenditures.
- Equipment: Equipment or machines are tools that a company invests in to produce good products to sell on the market.
- Land: Land is a strong long-term asset for the company because of its good appraisal value over time, further development may be needed to get good use out of it.
- Vehicles: Vehicles are transporting tools used by staff for delivering goods or picking up clients and other business purposes.
- Computers or servers: Computers or servers are instruments used to support the operation of a business through communication, reports, and logistics. It is a real-time machine that simplifies the reports and works data to be able to conclude the next business opportunity.
What are the examples of Capital Expenditures?
Businesses see capital expenditures as an essential way to sustain their operations. It is a budget allocation that will serve and maintain the non-consumable property to maintain the business workflow. Capital expenditures are also ways to acquire new assets or expand the company’s acquisitions.
Listed below are examples of capital expenditures.
Example 1: An entrepreneur opens a new furniture shop and decides to buy and provide the need for equipment and space. The owner's calculation states the capital expenditure of the new furniture shop in 2018.
D for Depreciation = $20,000
B for PP&E at the end of 2021 = $55,000
A for PP&E at the beginning of 2021 = $40,000
To begin with these given values; the business owner can start calculating the capital expenditure by subtracting B to A; the preliminary computation will provide a difference of $15,000 that will be added then to D, to get the sum of $35,000 as the Capital expenditure cost.
Example 2: An entrepreneur opens a boutique and spends money to buy new equipment, including computers to be used in their workspace. The expense and financial reports must be gathered to compute the capital expenditures of the business in 2021.
D for Depreciation in 2021 = $25,000
C for PP&E for the current period = $20,000
P for PP&E for the prior period = $15,000
To calculate the company’s capital expenditures, the given value will be implemented in the formula.
Capital expenditures = (C - P) + D
Capital Expenditures = ($20,000 - $15,000) + $25,000
Capital expenditures = $5,000 + $25,000
Capital expenditures = $30,000
Therefore, the boutique’s capital expenditure for 2021 is $30,000.
What is the formula use for Capital Expenditures?
Business owners can formulate the calculation using financial records like balance sheet and income statement that are both own by the company.
Listed below is the formula used for calculating Capital Expenditures.
capital expenditures = PP&E (current period) - PP&E (prior period) + depreciation (current period)
Capital expenditures are also used in calculating free cash flow to equity (FCFE). Free Cash Flow to Equity is the amount of cash available to equity shareholders. Below are the two formula of CapEx as used for calculating FCFE.
- FCFE=EP−(CE−D)×(1−DR)−ΔC×(1−DR)
Where:
FCFE=Free cash flow to equity
EP=Earnings per share
CE=CapEx
D=Depreciation
DR=Debt ratio
ΔC=ΔNet capital, change in net working capital
- FCFE=NI−NCE−ΔC+ND−DR
Where:
NI=Net income
NCE=Net CapEx
ND=New debt
DR=Debt repayment
How to calculate Capital Expenditures?
Listed below is the step-by-step guide on how to calculate capital expenditures.
1. Obtain the company’s financial statement: The financial statements along with all accounting documents that the company has can determine the company's capital expenditures by calculating the records for 2 years are essential for the business owner.
2. Subtract the fixed assets: To determine the changes in the fixed assets, the current asset must be subtracted from the previous year’s fixed assets that can be found on the financial statement. It is an essential way of knowing what assets should be avoided based on the report of previous acquisitions.
3. Subtract the accumulated depreciation: To determine the year-end's total depreciation, the sum of the collected amount from the previous year's depreciation to the current that just ended. The business owner will now determine the capital expenditures generated according to the period it is set.
4. Add total depreciation: After getting the difference between the fixed asset from different periods, add the depreciation amount to the determined fixed asset amount. It will show the total capital expenditure results that the owner is looking for.
What is the importance of Capital Expenditures?
Capital expenditures are very important for the company because they allow it to increase the wealth produced and ensure its growth. A low investment in its production equipment can expose the company to significant risks. This can lead to a drop in production due to the use of obsolete equipment or a lack of maintenance. This is why it is essential for the company manager to find the right financial balance between maintaining existing equipment or replacing it with new equipment. From a long-term financial planning perspective, capital expenditure analysis helps executives understand whether an investment (asset) offers an attractive rate of return. Other important considerations are initial costs, irreversibility and depreciation. It is critical to understand the long-term benefits of investing in an asset and its financial impacts. When a company is considering a long-term investment in new equipment, it is important to consider the acquisition cost and maintenance cost to accurately calculate the projected return on investment. The investment decision is, by nature, a bet on the future, it is a financial commitment on the medium or long term for the company. When the head of the company takes the decision to invest in an uncertain economic context, if the pessimistic forecasts come true, it will be difficult for the company to disinvest. Depending on the nature of the investment, it is still possible in some cases to sell the asset to limit the damage. Finally, one must keep in mind that long-term investments increase depreciation and amortization in the future. The increase in depreciation and amortization decreases the pre-tax result, which translates into paying less taxes and increasing the available cash.
What is the ideal ratio of Capital Expenditures?
The ideal capital expenditure ratio is a ratio that determines the company's ability to buy physical assets using the income generated by the operations. This ratio is called "Cash-flow to CAPEX" if it is greater than 1, the company is able to finance its capital expenditures for the acquisition of new assets. If the ratio is less than 1, it means that the company is having difficulty generating enough revenue to acquire new assets.
The following formula is used to calculate this ratio:
Cash-Flow to CAPEX = Cash-Flow from Operation / Capital Expenditures
If the company pays dividends to its shareholders the formula becomes :
Cash-Flow to CAPEX = (Cash-Flow from Operation – Dividends) / Capital Expenditures
Where to find capital expenditures on cash flow statement?
Capital expenditure is found underneath the cash flow investing activities within the cash flow statement. CapEx is sometimes termed different from other companies buying property plant machines and other capital spending note that analysts or investors might notice; furthermore the in and out of cash are stated in the company's cash flow statement.
Capital expenditures logically have an impact on the cash generated by the company. We will therefore find these capital expenditures in the cash flow statement under investing activities. Keep in mind that capital expenditures will also indirectly impact the company's other financial statements, such as the balance sheet and income statement. CAPEX expenditures are investments in the purchase of new assets, sometimes replacing existing assets. Therefore, it will impact the tangible and intangible assets in the "Long-term assets" section of the balance sheet. The acquisition of fixed assets generates annual depreciation and impairment charges that are recognized in the income statement.
Is Capital Expenditure the same as Cash Flow Investing Activities?
No, capital expenditure is not the same as cash flow investing activities. Capital expenditures are terminology used to describe the acquired long-term assets that can be property, plant, and equipment. The method is known for gauging the company’s investment capacity, which means that the company's appraisal value would be suitable as a valuable stock. However, the records of expenses purchasing the long-term assets and all the company spending including the CapEx are under the cash flow investing activities.
Is capital expenditure a Cash Flow Operating Activity?
No, capital expenditure is not a cash flow operating activity. Capital expenditures focus on the acquisition of new assets such as property plants and equipment, also known as (PP&E) while needing some adjustment and keeping such assets share the process. The cash flow operating activities however, records the cash made during a business activity like offering services and how the goods are sold. Cash flow operating activities do not include CapEx and thus are limited to operational activities and the net cash acquired from the operation.
What is the difference between Capital Expenditure from Revenue?
The difference between capital expenditure and revenue expenditure is that capital expenditure is considered a one-time big acquisition that is mainly for the company’s workhorse to create long-term profit. Revenue expenditures, on the other hand, are spending that occurs within the operational side of the business, such as purchasing raw materials, office supplies, fuel, minor equipment repair, and outsourcing. However, capital expenditures vs revenue expenditures are both important in the business as it has each role to fulfill in the business aspect; it provides the mechanisms to generate income while maintaining a stable workflow.
