What is Capital Expenditure (CapEx) and How Does it Work?
17 October 2022
Expenses are an important part of a growing company and capital expenditure is one of them. Capital expenditure or CapEx occurs when a company uses its funds to purchase or maintain immovable, non-consumable, and fixed assets. Companies frequently use it to grow their business. With investment in their capital expenditure, businesses can pursue new initiatives or investments. Read on to understand capital expenditure, how companies use it and how it is calculated.
What is Capital Expenditure (CapEx)?
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.
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.
Understanding Capital Expenditure with an 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:
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.
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.
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.
Q1. What should capital expenditures include?
Ans: Capital expenditure includes the acquisition of new equipment, machinery, land, plant, buildings or warehouses, furnishings and fittings, business vehicles, software and even a patent or a licence.
Q2. What does not qualify as a capital expenditure?
Ans: When a company makes a revenue expenditure, the gain is immediate rather than long-term. Wages or salaries paid to manufacturing workers, as well as the purchase of machine oil, are examples of revenue expenditure and are not termed as capital expenditure.
Q3. What is the significance of capital expenditure?
Ans: In terms of long-term financial planning, CapEx analysis assists companies in determining the rate of return of an asset
Q4. What effect does capital expenditure or CapEx have on financial statements?
Ans: A capital expenditure can have various effects on the income statement. If you purchase an asset that increases your manufacturing capacity or sales volume, you can enhance your revenue.
Before you go…
Looking for instant 🚀 personal loans 24*7 anywhere, anytime? Get personal loans up to ₹20 lakh starting at 9.9% p.a. Install the Navi app now!
Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
We are a diverse group of writers, editors and Subject Matter Experts striving to bring the most accurate, authentic and trustworthy finance and finance-related information to our readers. Our mission is to simplify jargon and industry lingo. We believe sharing knowledge through relatable content is a powerful medium to empower, guide and shape the mindset of a billion people of this country.
How To Apply For A Business Loan Online – Its Types, Features & Eligibility Criteria
A business loan is a borrowed capital from a financial institution for the purpose of growing or ex...Read More »
Gig Economy – Definition, Advantages and Disadvantages
While freelance or ‘gig work’ has always been an option for supplementing one’s income, it is...Read More »
What is GAAP in Financial Reporting and How is it Different from IFRS?
Businesses need financial reporting at every stage. It makes the business owners and other stakehol...Read More »
What is Revenue Sharing? How is it Different from Profit Sharing?
Businesses may decide to give a part of their total revenue to various stakeholders as a reward for...Read More »
What is Solvency Ratio? How is it Different from Liquidity Ratio?
It is very common for businesses to take out loans to meet their business expenses, gather funds fo...Read More »
What is the Meaning and Scope of the Paasche Index? How is it Calculated?
There are various ways to assess and compare price changes in commodities and services that have oc...Read More »
What is Market Penetration? How to Calculate and Increase it?
Entrepreneurs worldwide face some common challenges while coming up with ideal business strategies ...Read More »
Understanding Forensic Accounting: Working, Types and Advantages
Financial discrepancies in a company’s balance sheet can occur more often than you think. If this...Read More »
What is Financial Ratio Analysis? – Know the Types, Advantages and Disadvantages
Ratio analysis is a process that enables people to assess an organisation’s financial health. The...Read More »
Startup India Scheme Details Every Entrepreneur Should Know
Startup India scheme is an initiative by the Government of India to “to build a strong eco-system...Read More »
Acid Test Ratio: Meaning, Formula and Calculation
During its business cycle, every firm has to face short-term and long-term liabilities. Its ability...Read More »
What Is A Trademark? How Is It Different From Copyright?
Trademark is a recognisable phrase, word, emblem, or symbol that identifies a particular product an...Read More »
Diwali 2022: Diwali Holidays – The Festival of Lights
The ‘Festival of Lights’ is one of the biggest and most anticipated festivals in India. This is...Read More »
Best Index Funds – Top 20 Index Funds in India
Index funds replicate the performance of a stock market index, such as the Sensex or Nifty 50 to ge...Read More »