Capital Expenditure

Capital expenditure increases the productive capacity, efficiency, or useful life of an asset. They are long-term investments in ample facilities and come under non-current assets in financial position statements. They are materially significant, for example, procurement of new furniture.

In other words, capital expenditure can be defined as all those expenditures incurred by the business to purchase, upgrade and maintain tangible and non-tangible assets such as buildings, property, industrial plant, accounting software, or other equipment.

Capital expenditure is any expenditure incurred which a business capitalizes and shows in its financial position statement as an asset.

The formula used for calculating capital expenditure is as follows:

 CapEx = ΔPP&E + Current Depreciation

Where:

CapEx = Capital Expenditure

ΔPP&E = Change in total property, plant, and equipment

Understanding Capital Expenditure (CapEx) in Detail

CapEx basically provides information regarding how much an entity has invested in its operating assets in order to expand or maintain its business operations. In other words, CapEx can be defined as any expense that an entity capitalizes and recognizes as a fixed asset on the face of its statement of financial position instead of treating it as an expenditure and showing it on its statement of profit or loss.

The amount an entity is likely to invest in capital expenditures basically depends on the sector/ industry in which it operates. Entities working in capital-intensive industries are required to invest huge amounts in their fixed assets. Examples of industries that require large investments to be made in fixed assets include automobile manufacturing, steel production, oil production and refining, transportation, and telecommunication. All the above-mentioned industries require a major investment in tangible and intangible fixed assets.

CapEx features in a company’s cash flow statement under the head ‘cash flow generated from investing activities’. Different business entities present CapEx in different ways, and an investor or analyst may see it presented as acquisition expense, expenditure incurred on PP&E, or capital spending.

Difference between Operating Expenditures (OpEx) and Capital Expenditure (CapEx)

CapEx is very different from an OpEx and therefore these two should not be mixed with each other. Operating expenditures can be defined as shorter-term expenditures that are incurred for meeting the costs of operating a business on a daily basis. Operating expenses unlike capital expenses are fully tax-deductible and that too in the financial period in which they occur.

In accounting terms, an expenditure is classified as a capital expenditure when a company incurs an amount on the purchase of a new operating fixed asset or incurs an amount on improving the life of an operating fixed asset it already owns. However, if an expense is incurred to maintain the current condition of a fixed asset then such an expense would be recognized in the entity’s statement of profit or loss.

How CapEx Can Be Used?

Apart from assessing and analyzing the investment an entity has made in its tangible and intangible operating fixed assets, CapEx is also used for calculating a number of ratios when analyzing an entity’s financial performance and health. One of the ratios in which it is used is the cash flow to capital expenditures ratio. This ratio is used for assessing an entity’s capability to acquire non-current assets using free cash flows.  The formula used for calculating a CF to CapEx ratio is as follows:

CF to CapEx ratio = Cash Flow from operations/ CapEx

Where:

CF to CapEx ratio = Cash flows to capital expenditures ratio

Capital expenses are also used when computing free cash flow to equity – FCFE. FCFE can be defined as the cash amount that is available to an entity’s equity stockholders. The formula used for calculating FCFE for an entity is as follows:

FCFE = EP – (CE – D) × (1 – DR) – ΔC × (1 – DR)

Where:

CE = CapEx

EP = Earnings per share

DR = Debt ratio

D = Depreciation

ΔC = Change in net working capital