Capital Expenditure (aka CapEx) is an important figure to accountants, investors, entrepreneurs, and financiers alike. Here’s everything you need to know about it, including what it is, why it’s important, and how we calculate it.
Investors like to see consistent growth in a company, and you are probably seeking better ways to figure out which companies are achieving this growth.
There are plenty of stories in the media that convey a feeling that corporations exist to provide huge bonuses to executives, but the reality is that corporations exist to return value to shareholders and ensure growth over a long period of time.
So, how do corporations use the fruits of their labour to grow the business? One of the tools at a corporation’s disposal is called capital expenditure.
This will be your ultimate guide to capital expenditures so you understand what it is and how corporations use it on their earnings statements.
What Is Capital Expenditure (CapEx)?
Firstly, what exactly is Capital Expenditure?
Capital Expenditure (or “CapEx” for short) refers to expenditure for capital items.
The terminology dates back to several decades ago, when types of expenditure were broadly classified into:
- Revenue Expenditure (aka Revenue Expenses), and
- Capital Expenditure (aka Capital Expenses)
Back then, expenses that related to the day-to-day operations of the business were dubbed “Revenue Expenditure”.
The thinking was that these expenses are necessary to generate revenue on a day-to-day basis.
It’s still called “Revenue Expenditure” in many parts of the globe, but many people also tend to call this type of expenditure an Operating Expenditure (or “OpEx”, Operating Expense).
They’re both essentially identical.
Capital Expenditure, on the other hand, relates to expenses for capital items.
Broadly speaking, this includes expenses relating to buying, updating, repairing, or improving a “non-current asset” (aka “fixed asset”).
In principle, CapEx relates to expenditure which allows a firm to generate revenues in the long run.
Without these expenses, firms will not be able to grow sustainably.
Another way to think of Capital Expenditure is that a company is buying something for the specific purpose of increasing its capital generation capabilities.
What Are the Types of CapEx?
CapEx includes a variety of items, though the best way to think of CapEx is that it involves buying or materially improving fixed assets like:
- equipment, and
- technology, for example.
Another good way to think of CapEx is that companies are reporting CapEx on most things that have a very long useful life expectancy.
- Buildings and Property: this one is fairly straightforward since building and property almost always have a lengthy period of usefulness. Companies will purchase buildings and property for specific projects and are the most basic CapEx type.
- Equipment Upgrades: upgrading and maintaining equipment is a critical part of continued capital generation. For that reason, these expenses are considered CapEx.
- Computers and Hardware: as mentioned earlier, CapEx includes technology. Computers and hardware relating to computers are all used to generate capital, especially as our world continues to advance digitally. While the cloud is becoming more ubiquitous, many companies still maintain in-house networking hardware to support their business needs. The initial purchase is included in CapEx as are upgrades and maintenance.
- Vehicles: Everyone knows that vehicles are depreciating assets, but we’ll revisit this concept in a bit. Vehicles are, in many cases, critical to performing work and generating capital, so their purchase and maintenance costs are included in CapEx.
Broadly speaking, all of these types of items – buildings and property, equipment, vehicles, etc – tend to be classified as “Property, Plant, and Equipment”.
We’ll touch on this further down.
For now, let’s think about how to calculate CapEx.
How to Calculate CapEx (Capital Expenditure)?
CapEx is calculated by using this formula:
- refers to Capital Expenditure
- refers to Property Plant and Equipment
- reflects depreciation for the given period.
- The subscripts and in represent the timepoints at which is considered
In simple English, CapEx is simply the difference between current and previous PP&E, plus depreciation.
Put differently, CapEx is equal to the change in PP&E, plus depreciation.
Thus, the CapEx formula above can also be written as:
- and represent Capital Expenditure and Depreciation as before
- is the change in PP&E (i.e., )
Let’s now consider the individual elements of the CapEx formula.
Property, Plant, and Equipment (PP&E)
Property, Plant, and Equipment (PP&E) represents the book value/accounting value of a firm’s land and buildings, vehicles, machinery, etc.
Importantly, it excludes intangible assets like software, goodwill, patents, and trademarks.
This is true at least at the time of writing and has been true for several decades.
But, as the world evolves and accounting standards catch up, it’s possible that at some stage, accounting standard setters and investors will begin to see the purchase and maintenance/upgrading of intangibles as part of CapEx.
For now, we’re going to put aside our spirations of better accounting standards. And think about where we can find PP&E.
PP&E is found on a company’s Balance Sheet (aka Statement of Financial Position).
Depending on the size of the company, and the accounting standards it’s following, you’ll either see:
- PP&E as an individual line item on the Balance Sheet, or
- Individual components of PP& as separate line items on the Balance Sheet
If it’s the latter case, it’d be a simple case of adding the individual components of PP&E to come up with a final value.
In order to calculate CapEx, you must find the difference between the PP&E values of the current and previous reporting periods.
You would then add the depreciation for the year, which you’d get from the company’s Income Statement (aka Profit and Loss Statement).
Since we’re exploring the individual components of the CapEx formula however, let’s quickly go over depreciation, shall we?
Depreciation is an accounting convention that is broadly interpreted in two main ways:
- It’s a way of “apportioning” the costs of non-current assets over their useful economic life (UEL).
- It’s an accountant’s estimate for the loss in value of a non-current asset.
Strictly speaking, accountants will almost always describe depreciation in the former light (that it’s a way of apportioning the costs of non-current assets over their useful economic life).
And that is the correct interpretation of depreciation.
It’s relatively harder for beginners to understand this interpretation, however.
That is why the second interpretation is often widely used/adopted.
It’s not wrong per se. But, strictly speaking, it isn’t quite right, either.
For the purpose of calculating CapEx however, either interpretation will suffice.
The key takeaway is that depreciation is added to the change in PP&E in order to calculate Capital Expenditure.
And as we said earlier, you’d find the value for depreciation in the company’s Income Statement.
Note that you can also find it in a company’s Cash Flow Statement (aka Statement of Cash Flows).
But this depends on how the Cash Flow Statement is prepared and presented. For instance, some versions will start with Earnings Before Interest and Tax (EBIT), in which case they’d need to add back depreciation.
A Cash Flow Statement that starts with EBITDA on the other hand, wouldn’t need to do so. Thus, you would not see a value for depreciation in that particular Cash Flow Statement.
CapEx vs OpEx
It’s important to remember that there are other categories of expenses. And oftentimes, people end up confusing capital expenditures with operating expenditures.
Operating expenditure, also known as “OpEx” or Operating Expense, are those expenses necessary for daily business operations, generally including anything with a useful life of less than a year.
These are also dubbed “Revenue Expenditure”, as we highlighted earlier in this article.
OpEx would include things like office supplies, utilities, travel, property insurance, and general repairs and maintenance of property, plant, and equipment (as long as it doesn’t increase the value of the PP&E).
Any expenditure that increases the value of PP&E is a Capital Expenditure.
OpEx is simply reported as operating expenses on the Income Statement (aka P&L). They’re simply are a cost of doing business.
A company may choose whether a particular expense should be CapEx or OpEx. It really depends on the business needs. One of the best modern examples of this situation is data storage and networking.
Many companies maintain their own internal network and storage in support of their data management.
Any spending on new server equipment and storage held in-house would be considered CapEx.
However, the cloud has allowed companies to opt for their networking to be leased from any of the major cloud computing companies like Microsoft with Azure or Amazon with AWS.
If a company’s networking is conducted in this way, the monthly cloud spend would be considered OpEx.
What Does CapEx Mean For Investors?
How a company spends its money is an important metric for all investors.
For that reason, CapEx is followed closely to see whether a company is actively investing in future growth.
Capital expenditures tend to be quite large when compared to OpEx.
Companies need to actively invest in CapEx in order to remain competitive and sustainable.
Thus, investors may see flat CapEx as an indication that the company is not making any new investments for future projects. Of course, as highlighted earlier, it also depends on how a company reports CapEx.
Remember that what shows up in a given financial statement is heavily influenced by accounting standards.
If the accounting standards are outdated or irrelevant, then so are the values that show up on financial statements that are the result of those redundant standards!
CapEx can be a bit vague from the perspective of an individual investor because corporate accountants can report CapEx in several different ways.
The company might be investing heavily in their IT future, but they may be using cloud-based services that are reported as OpEx.
Thus, it’s important for investors to analyse a company’s CapEx in conjunction with its other activities.
Comparing 2 companies CapEx by themselves is far from good analysis.
What’s Next – Capital Expenditure (CapEx)
CapEx is an important part of a company’s reporting for a number of reasons.
A corporation’s primary purpose is really to grow over a long period of time to maximise value for its shareholders.
CapEx can provide investors with an idea of how active a company is investing in that future value growth.
While companies may vary in the ways they report CapEx, you can learn how to track past trends in CapEx to obtain a better understanding of how a company is growing.
Learning and using data-driven investing strategies can pave the way for a robust application of CapEx for investors.
Hopefully, all of this makes sense.
That’s a wrap from us for now.
Keep learning, keep growing!