Capital Expenditure

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.

What is Capital Expenditure?

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 license, trademark or patent.

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 for capital expenditure 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.

Types of Capital Expenditure

In a broader sense, capital expenditure is classified into three groups –

• Expenses incurred to reduce costs.
• Expenses incurred to increase earnings.
• Expenses incurred on non-economic grounds.

Furthermore, the capital analysis concentrates on three types of outlays –

1. Major projects
2. Routine Expenditure
3. Replacement

Capital Expenditure Example

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 Cash Flow Statement of Ambuja Cement Limited as on 30th December 2019:

Significance of Capital Expenditure 

The following pointers emphasise the significance of capital expenditure for a firm –

• CAPEX helps financial analysts to gauge a firm’s investment activities and their extent in general.
• The impact of capital expenditure is mostly felt in the long-term. In fact, the scale of manufacturing activities is primarily governed by a firm’s past CAPEX concentration. Also, the current capital expenses tend to pave the way for future operations. 
• Capital expenditure proves useful in calculating free cash flow to equity for a firm. It helps to determine the free cash flow of an organisation with respect to its equity.
• Such expenditures are often irreversible and cannot be undone without being subject to losses. For instance, most firms invest in capital equipment that is customised as per their requirements. Consequently, such customised material and machinery do not bode well in the general capital market.
• Typically, capital expenditures incurred by firms based in industries like – manufacturing, telecom, production, oil exploration, etc. are quite high in terms of value. Investing in physical assets like – PP & E generate profit in the long-term. However, the initial cost of investment is significantly high. Furthermore, with the advancement of technology, capital cost also tends to increase.
• CAPEX is also responsible for increasing the asset account of business organisations. Nonetheless, once capital assets are put to use, they begin to depreciate, and as a result, their value continues to decrease.

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.

Challenges of Capital Expenditure

These are some common challenges that business entities face with capital expenditure –

• Problems related to measurement

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.

• Unpredictability 

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 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.

• Temporal spread

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.

Difference between Capital Expenditure and Revenue Expenditure 

The table below offers a fair idea about the key differences between capital expenditure and revenue expenditure in a firm –

Like 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. On doing so, they will be able to manage and regulate their CAPEX more successfully.