What is your business actually spending on? And how does that impact what your financial statements look like?
Finance professionals typically divide business expenses into two categories: operational expenditure and capital expenditure.
In this article, we’re going to look at the latter. We’ll explore what capital expenditure is, what kinds of expenses fall under this spending umbrella, and how capital expenditure impacts cash flow and financial record keeping.
What is capital expenditure (CapEx)?
Capital expenditure — regularly referred to as CapEx for short — refers to the spending a company undergoes to acquire, upgrade, and maintain business assets.
These assets are usually physical, such as property and manufacturing equipment, but some non-tangible assets, like licenses and trademarks, can also be considered capital expenditures.
The best way to think about capital expenditure is as an investment. If you’re investing in your business by purchasing a new fleet of vehicles, say, this would be a capital expense.
Capital expenditure is in contrast to operational expenditure.
While capital expenses are long-term strategic buys, operational expenditure covers everything a business needs to run its day-to-day, such as fuel for that new fleet of vehicles.
While operational expenses are immediately expensed on the income statement, capital expenditure is recorded as an investment on the balance sheet, with the cost being spread out as expenses over the useful life of that asset through depreciation or amortization.
We’ll get into how CapEx impacts financial statements shortly.
What types of expenses are classified as capital expenditures?
A purchase can be considered a capital expenditure if it's a long-term investment where the goods being purchased are expected to provide benefits to the business lasting over a year.
Imagine, for example, that a construction company buys a new steamroller.
That’s a large outlay and one that is going to provide benefits lasting far more than 12 months. In other words, it is an investment, so it is considered a capital expense.
The concrete and asphalt that the construction firm purchases — and that the steamroller flattens out — is not a capital expenditure. It's used within a year, on a specific project, providing short-term benefits.
Thus, it is considered an operating expense rather than a capital expense.
8 types of CapEx
To give you a better idea of what kinds of purchases are classified as capital expenses, here are 8 of the most common CapEx categories:
- Buildings and facilities: Office spaces, factories, and warehouses purchased and owned by the company (not leased).
- Land: The purchase of land for development or business expansions.
- Machinery equipment: Manufacturing machinery, heavy tools, and factory production equipment.
- Vehicles. Cars, trucks, and delivery vans that are used for regular business operations.
- IT. Computers, servers, large-scale software systems, and personal devices.
- Furniture and fixtures. Desks, workstations, office furniture, breakroom furniture, storage, and shelving.
- Infrastructure. Facility upgrades, investment in roadways and utilities, and renewable energy installations.
- Intangible assets. The purchase of patents, trademarks, and licenses that provide long-term value to the organization.
How is capital expenditure reported in financial statements?
Capital expenditure is not recorded immediately as an expense on the income statement, such as is the case with operational expenditure.
Rather, CapEx is reported on the balance sheet as an asset, reflecting its long-term value to the business.
It is then gradually expensed to the income statement over the course of its useful life using depreciation or amortization.
In the cash flow statement, CapEx is recorded as a cash outflow under the Investing Activities header.
Reporting such investments as capital expenditure has some important tax implications.
Because CapEx is not considered an expense, it is not claimed against business income in the same period that the expenses itself is paid. Rather, the depreciation on the asset expensed over time is used to reduce taxable income.
This is an important distinction for cash flow.
The cash goes out of your account when you buy the asset, but you’re only able to offset that against your income using the depreciation vehicle, which happens gradually over the period of the asset’s useful life.
Formula of CapEx
Here’s how to calculate total capital expenditure for the financial period:
CapEx: Ending PP&E (Property, plant, and equipment) - Beginning PP&E + Depreciation
Here’s what this looks like in practice.
Example of how to use CapEx
Imagine that the owner of a small bakery is looking to calculate its capital expenditure for the most recent financial period, having invested in a number of new assets during the year.
First, they look at the balance sheet that their accountant has just prepared for them and find PP&E listed in the assets section.
They also pull up that figure from the year before, so they now have the beginning and ending PP&E figures required to calculate CapEx.
Next, the bakery owner looks to their most recent income statement, finding the total deprecation number for the period under expenses.
Here are the figures they’ve identified:
- Ending PP&E: $90,000
- Beginning PP&E: $60,000
- Depreciation: $7,000
From there, they simply apply the formula discussed above:
CapEx: $90,000 - $60,000 + $7,000 = $37,000
Common challenges businesses face in managing CapEx
Managing capital expenditure comes with a unique set of challenges, especially for small businesses.
Here, we explore a few of the main ones.
1. Prioritization of projects
SMBs only have so much capital to invest, so balancing multiple projects while aligning them with strategic goals on limited resources can be tough.
This can put a major strain on cash flow and can sometimes, if not managed carefully, impact a company’s financial obligations.
2. Budgeting and forecasting
Capital expenditures can often take time to come to fruition, such as when building a new factory.
Market fluctuations, changing economic circumstances, and unforeseen expenses can all make forecasting tricky.
3. Performance monitoring
Measuring the success of capital expenditure projects, and in particular the ROI of that spend, can be challenging to small business owners.
This is especially true when it comes to capital expenses that are broad reaching. It may be hard, for example, to calculate the true ROI of investing in new machinery if there is no tangible impact on output or efficiency.
4. Risk management
Maintaining compliance with changing regulations, plus the risk of technological obsolescence, means that SMBs need to constantly be on their toes.
This can sometimes mean that investment in new infrastructure and other capital expenditure projects must be put on hold while aging tech is replaced or updated to comply with new legislation.
CapEx budgeting practices
Considering the numerous challenges involved in managing capital expenditure, what budgeting practices can SMBs implement?
Here are a few strategies that finance professionals use when weighing capital investments:
- Net present value (NPV): The difference between the current value of cash inflows and cash outflows over a period of time. This helps business leaders account for the time value of money and comparte the rates of return of different projects.
- Internal rate of return (IRR): The annual rate of growth that a CapEx investment is expected to generate. Think of it as ROI for CapEx projects.
- Payback period analysis: The time required for a CapEx investment to generate enough revenue to “pay back” the amount invested in the project.
Get on top of capital expenses
Capital expenditure is critical for businesses that wish to invest in long-term growth, drive future revenue increases, and maintain a competitive edge.
Since CapEx requires significant cash outflows in the short term, it's vital that SMB leaders are highly educated when it comes to capital management.
Dive into our library of articles on business capital here.
FAQ
Is CapEx Tax Deductible?
No, capital expenditure is not tax-deductible. At least not directly.
Capital expenditure is recorded as an asset on the balance sheet, and the value of the asset is depreciated over time and expensed to the income statement.
That depreciation is a tax-deductible expense.
How do capital expenditures affect cash flow?
Capital expenditure impacts cash flow as any large investment requires a significant upfront outflow, reducing the amount of available cash in the short term.
Basically, the cash leaves your account now to pay for the capital expense, but since it’s a long-term investment, your business won’t be reaping the benefits of those expenses for some time to come.
This said, capital expenditures are usually strategic investments designed to improve long-term cash flow, either by driving more revenue or reducing costs.
As such, capital expenditure impacts cash flow in two ways:
- CapEx reduces available cash on hand in the short term
- Good CapEx investments can increase cash flow in the long term
What are some capital expenditure examples by industry?
These are some of the most common kinds of capital expenses, categorized by industry:
- For manufacturing industries: Buying new machinery, building new factories, upgrading production lines.
- For telecommunications industries: Developing new infrastructure, upgrading existing data centers or building new ones, expanding the range of coverage.
- For oil and gas industries: The drilling of new wells, buying extraction equipment, construction or upgrading existing refineries.
- For retail industries: Upgrading POS systems, building and developing new locations, renovating existing stores.
