Capital Expenditure (CAPEX) is the expenditure made by a firm to improve its long-term assets or to purchase new equipment. It serves as a potent financial metric and helps financial analysts understand a company’s investment patterns.
CAPEX makes up the funds that business entities use to purchase, enhance or maintain long-term assets to boost the firm’s proficiency.
Typically, CAPEX is incurred to purchase long-term assets like – plant, equipment, building, machinery, furniture, and fixtures, among others. It also includes expenses incurred by way of purchasing intangible assets like licenses, trademarks,s or patents.
It must be noted here that capital expenditure lays a significant impact on a firm’s long-term and short-term financial standing. Resultantly, decisions about CAPEX are critical for the financial health and sustainability of a company.
Under general circumstances, CAPEX helps companies to maintain or boost their everyday operations.
The Formula is expressed as –
CAPEX = Net increase in PP & E + Depreciation Expense
Notably, the objectives of financial analysts pertaining to capital expenditure mainly focus on three aspects, namely, cost reduction, producing contemporary products, and increasing output.
In a broader sense, such expenditure is classified into three groups –
Furthermore, the capital analysis concentrates on three types of outlays –
As discussed before, capital expenditures are reported on a firm’s Cash Flow statement. The same is amortised throughout the lifespan of the assets involved. Since assets’ lifespan is often longer than the taxable period, capital expenditure is not reported as an expense in the Income Statement.
Take a look at this example below to gain a better idea about the treatment of CAPEX in a firm’s Cash Flow Statement.
An excerpt of the Cash Flow Statement of Ambuja Cement Limited as on 30th December 2019:
|Cash flow from operating activities||4,73,87,000|
|Cash flow from investing activities||-1,19,28,800|
|Net change in cash||2,91,64,500|
|Opening cash balance||6,09,31,100|
|Closing cash balance||9,01,18,800|
|Free cash flow|
|Operating cash flow||4,73,87,000|
|Free cash flow||3,07,12,700|
The following pointers emphasise the significance of capital expenditure for a firm –
The capital expenditure of some companies tends to be higher than others. As a result, financial analysts and investors choose to compare the CAPEX of one company with another operating in the same industry to gain a better idea.
These are some common challenges that business entities face with capital expenditure –
Business entities and financial experts often face problems when it comes to identifying and measuring the costs involved and benefits of a capital expenditure proposal.
Most large investments are made in capital assets with the hope of generating predictable outcomes. Regardless, such projections often do not pan out as per expectations because uncertainties characterise decisions related to the cost and benefits of capital expenditure. As a means to cushion such uncertainties, business entities need to factor in probable risks to mitigate and eliminate them effectively.
The cost and benefit involved with CAPEX are spread across an extended period. As a result, the temporal spreads often rise when it comes to estimating the discount rate and establishing equivalence.
The table below offers a fair idea about the key differences between capital expenditure and revenue expenditure in a firm –
|Parameters||Capital Expenditure||Revenue Expenditure|
|Definition||Capital expenditure is the cumulative expense incurred for acquiring capital assets or for upgrading the existing ones.||Revenue expenses are incurred for regulating everyday business activities.|
|Duration||Such expenses are mostly long-term in nature.||Revenue expenditure is incurred for the short-term.|
|Accounting treatment||It appears in the Cash Flow Statement of a company. In a Balance sheet, it appears under the header of fixed assets.||It appears on the Income Statement of a firm and is not reported on the balance sheet.|
|Capacity||Typically, such expenses are incurred to improve a firm’s earning capacity.||Such expenses are incurred to sustain earnings.|
|Advantage||These expenses yield benefits over a substantial period.||The benefits derived are limited to the current accounting year.|
|Occurrence||Such expenses are non-recurring.||They are incurred frequently.|
|Capitalisation||Capital expenditures are capitalised.||These expenses are not capitalised.|
|Treatment of depreciation||Depreciation is charged on capital expenditure every year.||Depreciation is not charged on revenue expenses.|
As discussed, capital expenditure is a crucial part of every business firm and tends to influence a firm’s financial standing significantly. Consequently, business entities must put effort into managing them effectively. For instance, they can adopt proficient capital expenditure budgeting practices like generating valuable reports, using efficient software, etc. In doing so, they will be able to manage and regulate their CAPEX more successfully.