What is capital expenditure (CapEx)?

Capital expenditures can be resource-intensive. Creating a capital expenditure budget helps your business reach growth goals while still maximizing the efficiency of investments. For example, if you only have $10,000 of free cash flow, it wouldn’t be wise to purchase a piece of machinery for $20,000. Budgeting for your capital expenditures allows you to obtain term assets and term investments without sacrificing the financial health of your organization.

Types of Capital Expenditures

CapEx investments differ by business and industry. For example, a company in the manufacturing realm would have more equipment and machinery needs compared to a software startup. Let’s go through some common classes of capital assets.

• Buildings – Buildings you construct or purchase are capital expenditures. This includes office space, warehouses, and production facilities.
• Land – Vacant land and the land your buildings are on are other examples of capital expenditures. However, land is a non-depreciable asset and will remain on the balance sheet at cost.
• Machinery and Equipment – Machines used in the production process or in general operations are capital expenditures if they exceed a certain limitation. Many companies use $2,500 as their baseline.
• Computer Hardware and Software – Computer equipment, like new laptops and servers, can be capitalized depending on the cost. Off-the-shelf software can also be categorized as capital expenditures.
• Furniture – Goods used to furnish your office, warehouse, or building can be included in your fixed assets.
• Vehicles – Vehicles owned in the company’s name are capital expenditures. Vehicles in the name of your employees but used for business purposes do not go on your business’s books.
• Intangibles – Intangible assets, such as goodwill, non-compete agreements, patents, and trademarks, represent capital expenditures. These items often result from mergers and acquisitions.

This list isn’t comprehensive, meaning you might have capital expenditures outside of this list. Be sure to consult with an accountant to determine if your cost should be treated as a capital expense.

Capital Expenditures vs Operating Expenditures

Capital expenditures differ from operating expenditures in a few key ways. For one, capital expenditures are items that have a useful life and economic benefit that extends beyond one year, while operating expenditures provide an immediate benefit. For example, painting new lines in your parking lot would be an operating expenditure, but replacing the entire parking lot would be a capital investment.

The recordkeeping for capital and operating expenditures also differs. Capital expenditures are reported on the balance sheet and depreciated their useful life, while operating expenses are immediately deductible on the income statement in the accounting period incurred.

Capital Expense Calculations

Capital expenditures contain two main components: the upfront investment and the depreciation or amortization for the period. Capital investments made during the period are found on the cash flow statement under the investment section. This section will include all purchases that are considered capital expenses, even items that are financed. Depreciation expense can be found on the income statement or in the operating section on the cash flow statement.

CapEx does generate a few notable calculations for investors, lenders, and members of management looking to evaluate existing and tentative investments. The first calculation determines the cost of capital expenditures during the current period. Here is the formula:

Capital Expenditure = Change in PPE + Depreciation

Let’s say that your company purchased $100,000 in machinery and has a total depreciation expense of $15,000 during the year. Your total capital expenditure would be $115,000 for the year.

Another important calculation is return on investment (ROI). This formula helps you determine the expected value from investing in capital expenditures. Here’s the calculation for ROI:

Return on Investment = Net Profit / Cost of Investment

Your business is considering purchasing a $50,000 machine. You believe that the machine will generate $5,000 in profit in the first year. To be approved by upper management, the investment must have an 8% or greater ROI. Dividing $5,000 by the initial investment of $50,000 generates an ROI of 10%, meeting your company’s qualifying criteria.

Determining the cash flow that your investments produce sheds insights into how effectively you are deploying your resources. The cash flow to CapEx formula is calculated with the following formula:

Cash Flow to CapEx = Cash Flow from Operations / Capital Expenditures

Your company is looking to implement best practices when it comes to maximizing the efficiency of your investments. As a result, management is targeting a cash flow to CapEx ratio of 1.5. Your cash flow statement shows cash flows from operations of $250,000. You invested $200,000 during the period. Using the above formula, your cash flow to CapEx ratio generates 1.25.

This indicates that your investments aren’t providing the necessary free cash flow from operations. There are a few factors that can cause this situation. For one, your latest investments might not be deployed yet. For example, if you put a new piece of machinery in service at the end of the year, it would not have time to materially impact operations.

Another reason for the lower ratio is that your resources aren’t being used effectively. Do you have bottlenecks in your operations that are hindering your efficiency? How can you use your existing capital expenditures to increase your profitability and free cash flow? One of the main capital expenditure best practices is tweaking your operations to fully leverage your CapEx investments.

Summary

• Capital expenditures are investments that provide an economic benefit greater than one year.
• Examples of capital expenditures include buildings, machinery, furniture, software, vehicles, acquisitions, and intangible assets.
• The capital expenditure cost for the period is calculated by adding initial capital investments, depreciation, and amortization.
• Calculating return on investment and cash flow to CapEx are two useful metrics for evaluating the effectiveness of your capital expenditures.