What is capital expenditure (CapEx)? - Overview, types, and importance
Capital expenditure (CapEx) is a crucial aspect of business finance, representing the investments made in long-term assets that generate future value. It involves spending on assets like buildings, equipment, and technology, that contribute to a company's growth, expansion, and efficiency.
Understanding what is CapEx is essential for businesses to make strategic financial decisions and allocate resources effectively.
The company or organization should be aware of its capital expenditures (CapEx), its types, significance, calculation methods, and its relation to depreciation and financial statements.
What is capital expenditure?
Capital expenditure refers to the funds invested in acquiring, upgrading, or maintaining long-term assets to generate economic benefits over an extended period. It involves purchasing physical assets or making improvements to existing ones that enhance a company's productive capacity or efficiency.
Unlike operational expenses (OpEx), which are incurred in day-to-day operations, CapEx typically involves substantial amounts and is spread out over several years. By investing in capital assets, businesses aim to boost productivity, competitiveness, and future profitability.
What is capital expenditure in accounting?
In accounting, capital expenditure is recorded as an asset on the balance sheet rather than an expense on the income statement. The cost of the asset is capitalized and gradually expensed through depreciation over its useful life.
For example, if a company purchases a new machine for $50,000 with an estimated useful life of ten years, the initial cost is not immediately expensed but recorded as an asset. Each year, a portion of the machine's value, based on its depreciation method, is expensed as depreciation expense on the income statement.
There is a depreciation factor for fixed assets. This indicates that a certain percentage is subtracted from their effective value each year. The cost of depreciation is subsequently shown as an expense on the income statement, which lowers the year's overall profit.
Capital expenditures do have an impact on the company's financial statement. However, it does not occur in the year of their purchase, but rather in the years that follow based on the depreciation value of the acquired assets.
Related read: What is a chart of accounts in accounting and how to map one
How does CapEX depreciation work?
CapEx depreciation is the gradual reduction in the value of a capital asset over its useful life. When a company purchases a long-term asset, it is considered an investment and not immediately expensed as a cost.
Instead, the asset's value is allocated over its useful life through depreciation. Depreciation expense is recorded in the income statement, reducing the net income and reflecting the wear and tear, obsolescence, or deterioration of the asset. This allocation of costs allows businesses to match the expenses associated with the asset's use over time.
Different capital expenditures have different rates of depreciation over time and it is calculated based on factors such as the estimated lifetime value of the asset and the net value of the fixed assets at the beginning and the end of the year.
Suggested read: What is net working capital and how to calculate it from balance sheet?
What are the types of capital expenditure(CapEx)?
1. Buildings
Investments in constructing or acquiring real estate properties. When a business purchases a building or even a floor on a building, it is a space that can be used for many different purposes such as turning it into an office, using it for research & development and more!
This building or space will help you develop your business and grow it over time and hence is considered a capital expenditure that will be depreciated over time.
2. Land
Purchases of land for future development or expansion. Similar to a building, the purchase of land is also a capital expenditure investment.
The land may be used for developing a factory, warehouse, office, etc. All of these will help grow the business and hence land is a capital expenditure.
3. Equipment and machinery
Acquisition of tools, machinery, and equipment to enhance production capabilities is a capital expenditure as it is helping grow your business by producing goods and products over a long period. Hence machinery and equipment are also capital expenditures.
4. Computers or servers
Investment in technology infrastructure to support operations. IT equipment has also become a form of capital expenditure thanks to the internet.
It has streamlined communication across the world which helps in networking, communicating, and carrying out business operations effectively.
5. Furniture
The purchase of office furniture, fixtures, or other tangible assets also serve the function of helping employees complete their tasks and be more productive for as long as the furniture is used. This makes it a type of capital expenditure.
6. Vehicles
Acquisition of vehicles for transportation or delivery purposes. Vehicles help improve your company’s ability to move goods from one place to another and provide value-added services such as delivery.
This makes vehicles a major part of business development for their entire lifetime and hence is a capital expenditure.
7. Acquisition of another company
Investments made to acquire or merge with another company. Usually, a company buys or merges with another company only when they see that there is potential for it to grow. So the acquisition of another company is also considered a CapEx.
8. Patents
Expenditure on acquiring or protecting intellectual property rights. A business’s intellectual property such as its brand name, logo, product, etc. is important to develop business because they help the entity to differentiate itself and stand out in the market.
This makes patents a useful tool to keep other companies from replicating your products exactly how they are and safeguards your brand and reputation which pays off over time.
9. Licenses for products and services
Investments in licenses or permits to offer specific products or services. When a business acquires specific licenses, it helps them offer products and services that are not that easily available for everyone and hence gives them the opportunity to grow or upgrade their business making licenses a type of capital expense.
Expense management now made simple
What is the difference between negative vs. positive CapEx?
Negative CapEx
Negative CapEx refers to situations where a company sells or disposes of existing capital assets. It represents a reduction in the company's capital base and typically occurs when assets become obsolete, are no longer needed, or are sold for strategic reasons.
An example of negative CapEx is when a company realizes that they don’t need an office space anymore as they can work remotely and the office space they have currently is not being used for any productive purpose.
Positive CapEx
Positive CapEx refers to the more common scenario where a company invests in acquiring new assets or upgrading existing ones. Positive CapEx aims to enhance a company's capabilities, productivity, or market position, contributing to future growth and profitability.
An example of positive CapEx is when the business decides to expand an already existing factory that they have to increase its production capacity.
Suggested read: Liquid vs non liquid assets - What's the difference?
What is the importance of capital expenditure (CapEx)?
Helps in expansion
Capital expenditure enables businesses to expand their operations, increase production capacity, or enter new markets.
Having a large sum of capital opens up the opportunity for a business to venture into new markets and territories or even expand its business horizontally by introducing new products and services.
With our comprehensive guide on international business expansion, get to know the crucial steps of expanding your business internationally. Whether you're an aspiring entrepreneur or an established business owner, exploring new markets can lead to tremendous growth opportunities. Take advantage of our expert advice and avoid common pitfalls in international expansion.
Helps in acquisition
CapEx allows companies to invest in acquiring new assets or companies, facilitating growth and market expansion.
For example, If a manufacturing business wants to increase its supply of goods, it might have to set up another factory and buy machinery and equipment for it. These will require a major capital expenditure.
An acquiring company has some obligations towards the target company’s management and operations. Read our article on how does financial liability function in an acquisition to know in detail what the obligations are.
Setting up business and launch
CapEx funds are often utilized to establish a new business or launch a new product or service.
Anyone who has ever started a business knows it takes money to make money. And depending on the type of business you plan to launch, you will need a significant amount of capital as an investment to kickstart your venture.
Growth of business
By investing in capital assets, companies can improve efficiency, productivity, and overall business performance, fostering long-term growth.
Capital expenditures help your business grow gradually and slowly over time as their utility is not transactional but rather more like an investment that compounds over time.
Related read: Understanding top line growth vs bottom line growth for businesses
Long-term effects on business
Capital expenditure decisions have lasting implications for a company's competitiveness, market position, and profitability, making them vital for long-term success.
No matter what type of capital expenditure you decide to invest in, it will have a long-lasting effect on your business. So make sure you thoroughly research and consult with a lot of folks before making a financial decision.
What are the characteristics of capital expenditure?
Capital expenditure involves investing in assets with a useful life extending beyond a single accounting period.
This nature of capital expenditure makes it a form of investment rather than an actual expense. Long-term investments in the form of capital expenditure must be well thought out and understood before you decide to invest in them.
Capital assets are subject to depreciation, where their costs are allocated over their useful lives.
Rather than being expensed in the same accounting year, capital expenditures like building or vehicles for logistics are depreciated over an estimated time of their entire life cycle.
Determining the exact impact and returns from capital expenditure can be challenging.
These types of expenditures are also often quite subjective from one business to another. Hence, you should determine which capital expenditures are really useful to the growth of your business and which ones you should avoid.
How to calculate capital expenditure(CapEx)?
To calculate capital expenditure, follow these steps:
• Step 1: Determine the beginning net fixed assets value, which represents the value of fixed assets at the start of the period.
• Step 2: Determine the ending net fixed assets value, representing the value of fixed assets at the end of the period.
• Step 3: Calculate the depreciation expense for the period.
• Step 4: Use the formula: CapEx = Ending Net Fixed Assets - Beginning Net Fixed Assets + Depreciation Expense.
For example, if a company had beginning net fixed assets of $500,000, ending net fixed assets of $600,000, and depreciation expense of $50,000, the capital expenditure would be $150,000 ($600,000 - $500,000 + $50,000).
What is CapEX on the cash flow statement?
On a cash flow statement, capital expenditure (CapEx) represents the cash outflows from investing activities related to acquiring or disposing of long-term assets.
It reflects the actual cash spent on capital investments during a specific period, providing insights into a company's investment in its future growth and productivity.
What is CapEX on the balance sheet?
On a balance sheet, capital expenditure (CapEx) is recorded as an asset under the category of "Property, Plant, and Equipment" (PP&E) or "Fixed Assets."
The cost of the assets is initially capitalized and gradually expensed over time through depreciation. CapEx on the balance sheet provides visibility into a company's investments in long-term assets and their value.
What is the difference between CapEX vs depreciation?
Depreciation is the systematic allocation of an asset's cost over its useful life, while capital expenditure (CapEx) represents the investment made to acquire or improve the asset.
Depreciation expense is calculated based on the initial cost of the asset, and it reduces the asset's value over time. CapEx and depreciation are closely related as CapEx influences the initial cost of the asset and subsequent depreciation expense.
What are the differences between CapEx vs OpEx?
Knowing the difference between CapEx vs OpEx is crucial for business finance folks. Listed below are a few points of differentiation between features of capital expenditure and operational expenditure:
What are the challenges with capital expenditure?
Capital expenditure often requires significant upfront investments, which can strain a company's financial resources.
It might hinder your cash reserves and the ability to carry out operational expenses. In such situations, it can be wise to use credit that you avail from a bank or lender to carry out day-to-day operations.
Once capital assets are acquired, they are challenging to reverse or sell without incurring losses. Capital expenditures tend to depreciate over time.
So if you face a situation where the investment is not paying off in the way that you want, even selling off your capital expenditure assets will cause a loss.
Estimating the future benefits and returns from capital expenditure can be uncertain, leading to potential risks and uncertainties. There is little control over capital expenditure’s outcome.
A business cannot be a hundred percent sure that their investment will pay off as there are many other uncontrolled factors.
Effective capital expenditure budgeting- best practices
1. Structure properly
Create a well-defined capital expenditure budgeting process with clear objectives, guidelines, and approval mechanisms.
2. Consider long-term goals
Align capital expenditure decisions with the company's long-term strategic objectives and vision. Determine how a particular capital expenditure will help in reaching this vision or goal.
3. Use the best budgeting software
Leverage advanced budgeting tools and software to streamline the capital expenditure planning and tracking process. Control your budget through modern tools to achieve efficiency.
Related read: 7 effective budgeting tips for small businesses
4. Collect and process accurate data
Ensure the availability of reliable and up-to-date financial and operational data to support informed decision-making.
5. Implement effective policies and guidelines
Establish comprehensive policies and guidelines to guide capital expenditure decisions, considering factors like risk assessment, return on investment analysis, and cost-benefit evaluations.
Plan, control, and monitor your business expenses with Volopay!
If you want to manage your capital expenditure and all your other business expenses efficiently, then you need to use an expense management software like Volopay.
Our platform is an all-in-one solution for companies when it comes to tracking expenses and controlling payments.
Here are some of the ways in which your business can stay ahead and plan all its business expenses:
1. Corporate cards
Using Volopay, you can issue physical and virtual corporate cards for your employees. The physical cards are great to issue for employees that tend to have a lot of travel-related business activities. It will help them manage their commute, dining, and entertainment expenses.
The virtual cards are great for any kind of online payment that needs to be made such as for booking flights or accommodation.
While the corporate cards give employees easy access to company funds for spending, the finance team of the company can also control this spending easily by setting custom spending limits on each card. This helps to avoid any unnecessary situation of overspending.
2. Money transfer through the platform
Apart from corporate card, a Volopay user can also use our system’s money transfer system to pay vendors and their invoices domestically or internationally.
Finance teams or admins can also set up approval workflows for payments depending on the volume so that no payment is made without being verified first.
3. Team or location-based budgets
The way your company budget is dispersed to your employees through Volopay is by using our budgets feature. It allows you to create and set a specific amount each team, project, or employee in a particular location can use for their expenses. This helps you plan and control budgets for teams and individual employees throughout the organization.
FAQ's
While there are many different examples of capital expenditures or a business, here are 6 of the most common capital expenditure examples - Buildings, land, equipment and machinery, computers or servers, furniture, and vehicles.
The two major types of capital expenditures are positive capital expenditure and negative capital expenditure.
No, depreciation is not a capital expenditure. It is the gradual allocation of an asset's cost over its useful life.
In accounting, capital expenditure refers to the investments made in long-term assets that provide future economic benefits.
Capital expenditure is crucial as it supports the acquisition, expansion, business setup, and growth of the business, and has long-term effects on a company's performance and profitability.