What is Capital Expenditure (CapEx): Its Examples, Importance and Calculation

Capital expenditure or CapEx means cash spent by a business to purchase or invest in new assets that are crucial to the company’s operations. It is to improve a company’s fixed assets and maintain tangible assets, such as property, manufacturing plants, or equipment resulting in the growth of the business. Repairing a roof, buying a new piece of equipment, machinery, software, furniture, establishing a new factory or anything beneficial for the future of the company are all examples of capital expenditure. 

In long-term financial planning, CapEx analysis supports the company management in deciding if a particular asset provides an attractive rate of return. Companies can then achieve a balance between conserving existing assets and having enough finances to expand its asset base.Changes to a company’s capital expenditure is a huge monetary decision and it must be approved at the company’s annual shareholder meeting.

How Does Capital Expenditure Work?

Capital expenditures in general are documented as a long-term investment rather than an expense. Since the corporation is incurring these expenses to grow its business and assets, it is called an investment.

Capital expenditures help companies and investors understand the quantum of funds the company has invested in growing the business. 

Buying new property and equipment, upgrading the software used, infrastructure, machinery, warehouse and furnishing are a few examples of common capital expenditures. CapEx also includes intangible assets such as patents and licences. 

However, expenses incurred for repairs or regular maintenance are not considered capital expenditures. They are instead documented as repairs. 

Importance of Capital Expenditure

CapEx purchases are present on the company’s balance sheet and are an important part of the cash flow statement. Following are some key reasons that help establish the importance of CapEx:

1. Long-term Financial Assets

The effects of capital expenditure are generally seen in the long-term since the benefits of capital expenditure being made now will be assessed by the output in the future. These expenses help give the company a direction to move forward, set goals and prepare budgets.

2. Boost the Business

It helps in boosting labour engagement, assessing the economy and its ability to generate more assets in the future.

3. Helps Determine the Rate of Return

In terms of long-term financial planning, capital expenditure analysis assists executives in determining if an asset delivers an attractive rate of return. Companies can then strike a balance between preserving current infrastructure and assets and retaining enough funds to engage in expansion.

4. It is Irreversible

Capital expenditures are found to be difficult to reverse without causing a loss to the organisation as the market for the old capital equipment is generally bad.

5. High Initial Investment

Capital expenditures are typically very expensive. Capital expenditures on physical assets such as buildings, or new equipment provide long-term financial benefits and help in the growth of the organisation, but require a large initial commitment that is substantially bigger than regular operating expenditures.

6. Depreciation of Asset’s Value

Capital expenditure boosts an organisation’s current assets. However, once capital assets are used, depreciation occurs, and their value decreases over time.

Capital Expenditure (CapEx) Formula

With help of an income statement and balance sheet, the following formula is used to calculate CapEx: 

CapEx = PP&E (current period) – PP&E (prior period) + Depreciation (current period)

You will need your company’s financial statements for the last two years to estimate capital expenditure.  

How to Calculate Capital Expenditure?

To determine capital expenditures, follow these steps: 

• Step 1: Get access to the financial statements for your organisation 
  You will need your company’s financial statements for the previous financial year to get the accurate and relevant information to determine capital expenditures. 
• Step 2: Determine the change in fixed assets
  Subtract the fixed assets stated on the prior year’s financial statement from the fixed assets listed for the current fiscal year. This will help you in determining the change in these fixed assets. 
• Step 3: Calculate the total depreciation
  Subtract the prior year’s accumulated depreciation from the current year’s accumulated depreciation. This will tell you about the total depreciation for that year. 
• Step 4: Add the total depreciation to the change in fixed assets
  Once you have calculated the total depreciation add it to the change in fixed assets mentioned above and you will get the final CapEx.

Capital Expenditure Example

Here is an example of capital expenditure calculation: 

For instance, assume you operate a business and decide to invest in new equipment and a larger facility in 2019. 

Depreciation = Rs.1,50,000 

PP&E at the end of 2018 = Rs.5,00,000 

PP&E at the beginning of 2018 = Rs.3,50,000 

With this data, you can compute your company’s capital expenditures for that fiscal year. 

Deduct the PP&E value at the start of 2018 (Rs.3,50,000) from the PP&E value at the end of 2018. (Rs.5,00,000). This will result in an Rs.1,50,000 change in PP&E. 

The following step is to add this amount in the depreciation expense (Rs.1,50,000). This will result in Rs.3,00,000 in capital expenditure for 2018. 

Types of Capital Expenditures

A company’s long-term value and financial growth are linked to a variety of assets. As a result, there are two major types of CapEx: 

1. Tangible

This includes the purchase of property, equipment, computers, vehicles, etc. and the cost to maintain them. These are the assets that will be used for several years to come. Acquiring such assets generally involves a depreciation charge as well. 

2. Intangible

For major corporations, software is a significant expense. This may include fees paid for software development, costs incurred in acquiring the particular software, and salary for staff who worked on the software development or upgrades. Software upgrades and purchases are considered intangible capital expenditures in certain circumstances and can be depreciated if certain criteria are met. A company’s purchase of a patent for a product or licence is also considered a capital investment.

Difference Between Capital and Revenue Expenditure

The difference between capital expenditure and revenue expenditure is primarily based on whether the purchases will generate revenue in the long or short term. A company’s capital expenditures or CapEx are funds used to purchase, improve and maintain tangible assets such as property, buildings or equipment in the long-term (over one year). They include one-time large purchases of fixed assets that will be used to generate revenue over a longer period of time. 

Revenue expenditures are recurring operating expenses, which are short-term expenditures required for the day-to-day operations of a corporation. Labour and raw material expenses are good examples of revenue expenditure.

Best Practices in Capital Expenditure Budgeting

Capital expenditure decisions are crucial to a company because of their high initial costs, irreversibility and long-term consequences. As a result, capital expenditure budgeting should be thoroughly and efficiently planned and executed. There are a few practices to keep in mind when it comes to capital expenditure budgeting: 

1. Create a Structure

Budgets for capital expenditures require careful consideration before they can be implemented as they are considered a massive expense for the company. Before beginning a project, determine the scope of the project, establish timelines, and ensure that the entire plan is reviewed and authorised. Implement more detail into the project to get a more precise budget.

2. Consider Long-term Efficiency

You must select whether you will purchase the capital asset with debt or with existing money at the outset of your capital expenditure project. Both options can be beneficial to your organisation, and different options may be required for different projects.

3. Gather Accurate Data

Accurate data is critical for effectively managing capital allocation for projects. You must collect all relevant information to produce a realistic budget and valuable reports.

4. Form Clear Guidelines and Regulations

Because capital expenditure management in a large firm may involve several stakeholders or departments, it is important to form clear policies for everyone to follow to keep the budget and workflow on track.

Also Read

Consumer Price Index (CPI) Explained – Calculation and How Does it Work

What is a Term Loan – Eligibility, Documents and Working

Final Word

Capital expenditure is incurred by businesses or corporations to invest in assets for long-term stability, eventually growing their business and increasing profit. Companies invest in properties and land to grow into new locations, upgrade building infrastructures to improve manufacturing, logistics, and  inventory storage, or technology to increase the efficiency of the organisation. If a company’s one time investment or development of an asset is anticipated to provide long-term benefits, the company is required to register the purchase as CapEx. The company then takes into account the depreciation of the asset over time and retains a portion of the purchase on its balance sheet.

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