What is Capital Expenditure (Capex)?
Capital Expenditure (also known as CapEx) refers to the financial outlay for the purpose of buying, maintaining or improving the fixed assets base (such as plant, property, and equipment) of the company. The money spent is considered for the sole purpose of buying new fixed assets, repairing the existing fixed assets or upgrading the existing capacity of the fixed assets. Capital Expenditure is a major financial decision for a company, must be formally approved at an annual shareholders meeting or a special meeting of the Board of Directors.
- buying fixed assets and sometimes intangible assets
- repairing an existing asset to improve its useful life
- upgrading an existing asset to increase its performance
Capital Expenditure Accounting
Going by the general rules of capex accounting, if the acquired property’s useful life is longer than the taxable year, then the cost must be capitalized. This cost is not charged to the profit and loss statement at once in the taxable year but is spread over the useful life of the asset in the form of amortization and depreciation.
#1 – Effect on Balance Sheet
Entire capital expenditure cost is capitalized on the asset side of the balance sheet. This increases the non-current asset base of the entity, while at the same time reducing the cash balance of the entity.
#2 – Effect on Income Statement
The capital expenditure costs are amortized or depreciated through profit and loss statement over the useful life of the asset.
source: Ford SEC Filings
#3 – Effect on Cash Flow Statement
Since the reduction in the cash balance of the entity is reflected in the balance sheet as at the end of the taxable year, this financial outlay does get reflected in cash flow statement under investing activities section as capital spending, purchases of property, plant, and equipment (PPE), acquisition expense, etc.
Capital Expenditure Formula
Capex can be calculated using two methods –
#1 – Gross Method
Capital Expenditure formula (using Gross Method) = Gross Property Plant and Equipment in Year 2 – Gross Property Plant and Equipment in Year 2
#2 – Net Method
Capex formula (using Net Method) = Net Property Plant and Equipment in Year 2 – Net Property Plant and Equipment in Year 2 + Depreciation in Year 2
Walmart Capital Expenditure Example
Shown below is the capital expenditure example of Walmart Inc. from its 2018 10-k SEC filings.
- From the above snippet of cash flow statement, it can be clearly seen that Walmart spent $10,051 million to buy property and equipment in the financial year.
- Since the expenditure was towards buying the fixed assets and the amount is very huge for it to be expensed in the income statement all at once, this expenditure could be classified as capital expenditure.
- More information about the exact nature of capital expenditure could be found out if one digs into the notes of the company which could be found in their financial filings.
- Many times, a pattern could be seen in the capital expenditures of the company. It could reflect that the company is expanding aggressively as per the strategic decision of the board of the company in order to cater to larger market share.
Capex is Different from Other Expenses
Some industries are more capital-intensive and some are less capital-intensive. The capital expenditures of an entity depending on the industry it operates in. Capital-intensive industries, like oil exploration and production, like telecommunication, like manufacturing, and utility industries, have the highest levels of capital expenditures.
- The capital expenditures are different from operating expenses (also known as Opex) as the Opex or the revenue expenses are fully text-deductible in the same year in which the expenses occur.
- Also, Capital Expenditure is a non-recurring strategic financial outlay that impacts the long-term asset base or something that could not be deducted in full in the year in which it was incurred and hence is amortized over the useful life of the capital asset.
- For example, buying a new car is a capital expenditure which could be amortized over its useful life (generally accepted as 5 years by the accounting rules and industry norms). Though after 5 years the car could still be in working condition, its value could only be charged to profit and loss statement only during the useful life for the tax-deductible purpose.
How to use of Capex?
#1 – CFO to Capex Ratio
Cash flow from operations to Capex is a very important ratio used by Financial Analysts. It is as follows:
If the ratio is greater than 1, it could mean that the company’s operations are generating cash, sufficient to fund its asset acquisitions. On the other hand, if the ratio is less than 1, it could mean that the company may need to borrow money to fund its purchase of capital assets.
#2 – Calculating FCFF
Also, CapEx is used in calculating the Free Cash Flow for the Firm (FCFF) as follows:
Presented below is the Free Cash Flow to Firm of Alibaba.
#3 – Calculating FCFE
Ans, CapEx is used in calculating the Free Cash Flow for the Equity Holders (FCFE) as follows:
Below is the FCFE calculation of Alibaba.
- Capital expenditures refer to the strategic financial outlay of funds for the purchase, improvement, or maintenance of long-term assets to improve the efficiency or capacity of the company. Long-term assets are usually physical, fixed and non-consumable assets like property, equipment, or infrastructure that have a useful life of more than one accounting period and intangible assets such as a software, patent or license depending on the business of the company.
- CapEx is stated in the cash flow statement under investing activities section as capital spending, purchases of property, plant, equipment (PPE) and acquisition expense, etc. The substantial effect of CapEx on the short-term and long-term financial standing of an organization warrants to making wise capital expenditure decisions of critical importance to the financial health of a company.
- Many companies try to maintain the levels of their historical capital expenditure to show investors that the managers of the company are investing effectively in the business and there are ample opportunities of growth in their business instead of making an idle pile of cash sitting in their balance sheet.
- Capital expenditure decisions are very critical to an organization due to their substantial initial costs, irreversibility and long-term effects. Therefore, budgeting for capital expenditures ought to be carefully and efficiently planned and executed.
This has been a guide to what is Capex? Here we discuss effect of Capex on Balance Sheet, Income Statement and Cash Flows. Here we also discuss Capex formula, and its uses in financial analysis including CFO to Capex, FCFF and FCFE. You may learn more about accounting from the following articles –
- Equity Research Interview Questions
- Tangible Assets
- Non-Current Assets
- Assets vs Liabilities
The post Capital Expenditure (Capex) appeared first on Learn Investment Banking: Financial Modeling Training Courses Online.