Investments in Property, Plant and Equipment
Written byJeff Schmidt
Updated March 10, 2023
What is a Capital Expenditure?
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 on the balance sheet (i.e., not expensed directly on a company’s income statement) and are considered an investment by a company in expanding its business.
Capex is important for companies to grow or maintain business by investing in new property, plant and equipment (PP&E), products, and technology. Financial analysts and investors pay close attention to a company’s capital expenditures, as they do not initially appear on the income statementbut can have a significant impact on cash flow.
Capital expenditures normally have a substantial effect on the short-term and long-term financial standing of an organization. Therefore, making wise capex decisions are of critical importance to the financial health of a company. Many companies usually try to maintain the levels of their historical capital expenditures to show investors that they are continuing to invest in the growth of the business.
When to Capitalize vs. Expense
The decision of whether to expense or capitalize an expenditure is based on how long the benefit of that spending is expected to last. If the benefit is less than one year, it will be expensed directly on the income statement. If the benefit is greater than one year, it must be capitalized as an asset on the balance sheet.
For example, the purchase of office supplies like printer ink and paper would not be capitalized but would instead be expensed.
The purchase of a building, by contrast, would provide a benefit of more than one year and would thus be deemed a capital expenditure.
Learn more about when to capitalize on theIFRS website.
Summary
- A capital expenditure, or capex, is the purchase of long-term physical or fixed assets used in a business’s operations.
- Financial analysts and investors pay close attention to a company’s capital expenditures, as they do not initially appear on the income statementbut can have a significant impact on cash flow.
- The calculation of free cash flow deducts capital expenditures. Free cash flow is one of the most important calculations in finance and serves as the basis for valuing a company.
Types of Capital Expenditures
There are normally two forms of capital expenditures:
- Maintenance capex: expenditures to maintain current levels of a company’s operations
- Growth capex: expenditures that will enable an increase in future growth
It is important to note that funds spent on repair or in conducting continuing, normal maintenance on assets are not considered capital expenditures and should be expensed on theincome statement.
Capex on the Cash Flow Statement
Capital expenditures can be found on a company’scash flow statement, under “investing activities.” As you can see in the screenshot above from Amazon’s 2022 annual report (10-k), Amazon had $63,645 million of capital expenditures related to the “purchase of property and equipment” in 2022.
Since this spending is considered an investment, it does not immediately appear on the income statement.
Capex on the Balance Sheet
Capex flows from the cash flow statement to the balance sheet. Once capitalized, the value of the asset is slowly reduced over time (i.e., expensed) via depreciation expense.
How to Calculate Net Capital Expenditure
Net capex can be calculated either directly or indirectly. In the direct approach, an analyst must add up all of the individual items that make up the total expenditures, using a schedule or accounting software. In the indirect approach, the value can be inferred by looking at the value of assets on the balance sheet in conjunction with depreciation expense.
Direct method:
- Amount spent on asset #1
- Plus:Amount spent on asset #2
- Plus:Amount spent on asset #3
- Less: Value received for assets that were sold
- = Net Capex
Indirect Method:
- PP&E Balance in the current period
- Less: PP&E balance in the previous period
- Plus: Depreciation in the current period
- = Net Capex
Read more about theCapex Formula.
Capital Expenditure and Depreciation
As a recap of the information outlined above, when an expenditure is capitalized, it is classified as an asset on the balance sheet. In order to move the asset off the balance sheet over time, it must be expensed and move through the income statement.
Accountants expense assets onto the income statement via depreciation. There is a wide range ofdepreciation methodsthat can be used (straight line, declining balance, etc.) based on the preference of the management team.
Over the life of an asset, total depreciation will be equal to the net capital expenditure. This means if a company regularly has more capex than depreciation, its asset base is growing.
Here is a guideline to see if a company’s fixed assets are growing or shrinking (over time):
- Capex > Depreciation = Growing fixed assets
- Capex < Depreciation = Shrinking fixed assets
How do Capital Expenditures impact Free Cash Flow and Valuation?
Free Cash Flowis one of the most important metrics in corporate finance. Analysts regularly evaluate a company’s ability to generate cash flow and consider it one of the main ways a company can createshareholder value.
While there are several different ways of calculating free cash flow (FCF), a simple method is:
· FCF = Cash from Operations– Capital Expenditures
Infinancial modeling and valuation, an analyst will calculate free cash flows in a DCF modelto determine the net present value (NPV) of the business.
Importance of Capital Expenditures
Decisions on how much to invest in capital expenditures can often be extremely vital decisions made by an organization. They are important because of the following reasons:
1. Long-term Effects
The effect of capital expenditure decisions usually extends into the future. The range of current production or manufacturing activities is mainly a result of past capital expenditures. Similarly, the current decisions on capital expenditures will have a major influence on the future activities of the company.
Capital investment decisions are a driver of the direction of the organization. The long-term strategic goals, as well as the budgeting process of a company, need to be in place before authorization of capital expenditures.
2. Irreversibility
Capital expenditures are often difficult to reverse without the company incurring losses. Most forms of capital equipment are customized to meet specific company requirements and needs. The market for used capital equipment is generally very poor.
3. High Initial Costs
Capital expenditures are characteristically very expensive, especially for companies in industries such as manufacturing, telecom, utilities, and oil exploration. Capital investments in physical assets like buildings, equipment, or property offer the potential of providing benefits in the long run but will need a large monetary outlay initially.
4. Depreciation
Capital expenditures have an initial increase in the asset accounts of an organization. However, once capital assets start being put in service, depreciation begins, and the assets decrease in value throughout their useful lives.
Challenges withCapital Expenditures
Even though capital expenditure decisions are very critical, they create more complexity:
1. Measurement Problems
The accounting process of identifying, measuring, and estimating the costs relating to capital expenditures may be quite complicated.
2. Unpredictability
Organizations making large investments in capital assets hope to generate predictable outcomes. However, such outcomes are not guaranteed, and losses may be incurred. The costs and benefits of capital expenditure decisions are usually characterized by a lot of uncertainty. Even the best forecasters sometimes make mistakes. During financial planning, organizations need to account for risk to mitigate potential losses, even though it is not possible to eliminate them.
Efficient Capital Expenditure Budgeting Practices
Major capital projects involving huge amounts of capital expenditures can get out of control quite easily if mishandled and end up costing an organization a lot of money. However, with effective planning, the right tools, and good project management, that doesn’t have to be the case. Here are some of the secrets that will ensure the budgeting of capital expenditures is efficient.
1. Structure Before You Start
Capital expenditure budgets need adequate preparations before commencement. Otherwise, they might go over budget. Before starting a project, you need to find the scope of the project, work out realistic deadlines, and ensure that the whole plan is reviewed and approved. It is at this stage that you should think about how many internal resources will be required by the project, including manpower, materials, finances and services. To have a more accurate budget, you should have more detail going into the project.
2. Think Long Term
At the start of your capital expenditure project, you need to decide whether you will purchase the capital asset with debt or set aside existing funds for the purchase. Saving money for the purchase usually implies that you will have to wait for a while before getting the asset you need. However, borrowing money leads to increased debt and may also create problems for your borrowing ability in the future. Both choices can be good for your company, and different choices might be needed for different projects.
3. Use Good Budgeting Software
From the beginning of the project, you should choose a reliable, practical program to manage the budgeting. The type of budgeting software you choose will depend on such things as the scale of the project, speed of the program and risk of error.
4. Capture Accurate Data
Accurate data is very crucial if you want to manage capital projects efficiently. To create a realistic budget and generate valuable reports, you need to gather reliable information.
5. Levels of Detail Should Be Optimal
Trying to put in too much detail will result in too much time being spent in gathering information to make the budget, which may be outdated by the time the budget is finished. However, too little detail will make the budget vague and, therefore, less useful. The right optimal balance needs to be found.
6. Form Clear Policies
Since the management of capital expenditures in a large organization may involve numerous employees, departments, or even regions, clear policies for everyone to follow should be put in place to put the budget on track.
Additional Resources
Thank you for reading CFI’s guide to Capital Expenditures. To keep advancing your career, the additional CFI resources below will be useful:
