Capital expenditures are payments made for goods or services that are recorded or capitalized on a company’s balance sheet instead of expensed on the income statement.
A capital expenditure (“CapEx” for short) is the payment with either cash or credit to purchase long-term physical or fixed assets used in a business’s operations. The expenditures are capitalized (i.e., not expensed directly on a company’s income statement) on the balance sheet and are considered an investment by a company in expanding its business.
What is meant by Capital Expenditure?
Capital expenditure refers to the funds used by a company to upgrade and maintain fixed assets as well as the money expended on undertaking new projects and investments. Capital expenditure is the money spent on acquiring fixed assets like new equipment, machinery, land, plant etc. and intangible assets such as patents or licenses, upgrading an existing asset, repairing an asset or repayment of loan. It is recorded on the balance sheet instead of the income statement as it is more of an investment that will derive returns in the long term than an expenditure.
What is the Purpose of Capital Expenditure?
Capital expenditures lead to the creation of assets in the long term. Capital expenditures are made by companies to increase the scope of operations of the company. It is also undertaken to add economic benefit to the operations. Features of Capital Expenditure The current decisions on capital expenditure will influence the future activities of the company – it provides direction to the company’s activity. It is an irreversible expenditure. These expenses are expensive, especially in industries such as production, manufacturing, telecom, utilities, and oil exploration. The capital invested undergo depreciation over a period of time. The accounting process related to capital expenditure is complicated.
Uses of Capital Expenditure
Capital expenditure can be used to derive a lot of important information regarding the company. For instance, the cash flow to capital expenditures ratio can be used to determine the company’s ability to acquire long term assets using free cash flow. It will show the fluctuations that the business will undergo through cycles of large and small expenditures. A ration that is greater than 1 implies that there is sufficient money to fund asset acquisitions. It is also used in calculation of free cash flow to equity (FCFE) which is the amount of cash that will be made available for distribution to the equity shareholders. A lower FCFE is a product of higher capital expenditure of the firm.
Types of CapEx
- Buildings may be used for office space, manufacturing of goods, storage of inventory, or other purposes.
- Land may be used for further development. Accounting treatment may be different for land specifically held as a speculative long-term investment.
- Equipment and machinery may be used to manufacture goods and convert raw materials into final products for sale.
- Computers or servers may be used to support a company’s operational aspects, including the logistics, reporting, and communication of operations. Software may also be treated as CapEx in certain circumstances.
- Furniture may be used to furnish an office building to make the space usable by staff and customers.
- Vehicles may be used to transport goods, pick up clients, or used by staff for business purposes.
- Patents may hold long-term value should the right to own an idea come to fruition through product development.
Formula and Calculation of CapEx
Capital expenditures are also used in calculating free cash flow to equity (FCFE). FCFE is the amount of cash available to equity shareholders. The formula for FCFE is:
FCFE=EP−(CE−D)×(1−DR)−ΔC×(1−DR)where:FCFE=Free cash flow to equityEP=Earnings per shareCE=CapExD=DepreciationDR=Debt ratioΔC=ΔNet capital, change in net working capital
Alternatively, it can be calculated as:
FCFE=NI−NCE−ΔC+ND−DRwhere:NI=Net incomeNCE=Net CapExND=New debtDR=Debt repayment
What is the Difference Between Capital Expenditure and Operating Expenditure?
Operating expenses are the costs incurred by the company in order to meet the day-to-day expenses of the company. It is a short-term expense that can be fully deducted from the company’s taxes in the year that the expense is incurred. Capital expenditure on the other hand, is an expense that has a life greater than one year and improves the useful life of an asset. Also, capital expenditures are not tax deductible, but can be deducted indirectly by way of the depreciation they generate.
FAQs
Why is Capital Expenditure important for businesses?
Capital Expenditure is crucial for maintaining and improving a company’s productive capacity. It can enhance efficiency, competitiveness, and the ability to generate future revenues.
How is Capital Expenditure financed?
Companies can finance CapEx through a combination of internally generated funds, debt financing, and equity financing. The chosen method depends on the company’s financial situation and strategy.
How is Capital Expenditure accounted for?
Capital Expenditures are typically capitalized on the balance sheet, which means they are recorded as assets. The costs are then depreciated or amortized over the useful life of the asset.
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