Everything you need to know about CapEx

Prophix ImageProphix May 9, 2024, 8:00:00 AM

When you purchase a new home or car, you’re looking forward to its value and utility lasting for years. The same goes for business – capital expenditures like plants, property, or equipment, are made with the expectation of long-term benefits.

Since these investments usually come with a hefty price tag, it’s important to understand everything there is to know about CapEx, including how to calculate it, common challenges to address, and examples.

What is CapEx?

Capital expenditures, or CapEx, are funds used by a company to acquire, improve, or maintain physical assets such as equipment, facilities, buildings, property, or technology. These investments are capitalized, meaning they are recorded as an asset on the balance sheet and depreciated over the asset's useful life. This depreciation is then reflected as an expense on the income statement over time, except in the case of assets like land, which do not depreciate.

Capital expenditures can expand a company's operational capacity or add economic value, affecting both the short-term and long-term financial health of the company.

What is CapEx in finance?

In finance, CapEx involves a company spending money to buy or improve its fixed assets, such as buildings or machinery. This spending is considered an investment in the company's future, aiming to increase its efficiency or expand its operations. These costs are shown on the balance sheet as assets and are slowly deducted as an expense over time through depreciation.

However, some assets, like land, don't lose value over time and aren't depreciated. Strategic CapEx decisions are important for a company's growth and long-term financial health, highlighting the need for careful planning.

What’s the difference between CapEx and OpEx?

The difference between CapEx and OpEx is that CapEx buys assets that you plan to use to generate revenue over a long period of time, whereas OpEx is the day-to-day costs of running your business.

The cost of CapEx assets is capitalized and depreciated, but operating expenses are fully deducted in the accounting period they are incurred. Operating expenditures can include payroll, insurance, utilities, marketing, and more.

CapEx investment examples

With CapEx fully defined, let’s look at some investment examples:

  1. Investing in a plant
    If you own a manufacturing business, you may need to invest in a new physical asset, such as a plant, to manufacture more products in response to increasing demand, expand into new markets, or enhance efficiency.

    Purchasing the plant would be considered a capital expenditure, which will depreciate over time as you use the plant, and as the building ages. However, a new manufacturing facility will give you the ability to generate more revenue by increasing your manufacturing capacity, improving your financial performance in the long-term.

  2. Investing in technology
    Service-based business may purchase new technologies to support program expansion, increase productivity, or to meet growing demand. And while technology is not always a physical asset, it is still considered a capital expenditure when it’s used beyond one year, as it can benefit the company in the long term.

    Capital investments in technology can include software (e.g., finance software like Enterprise Resource Planning, also known as ERPs), hardware (e.g., servers or data storage), or in-house solutions (e.g., software developed in-house).

  3. Investing in equipment
    Many non-profit businesses have equipment that may must maintain and upgrade to continue to support their mission. For example, a medical non-profit organization that provides free or low-cost medical services to underserved populations may need to purchase equipment like x-ray machines, ultrasound machines, or examination tables, which would all qualify as capital expenditures.

    This equipment provides long-term benefits to the organization, helping it deliver services more effectively to its target populations. Such equipment would be capitalized and depreciated over its useful life, reflecting its consumption and value reduction over time in the organization's financial statements.

How to calculate CapEx

Now, let’s look at how to calculate CapEx, so you can start investing in the long-term health of your business.

CapEx formula

To calculate CapEx, you can use the following formula:

CapEx = Current period PP&E (plant, property, & equipment) - prior period PP&E + depreciation 

Depreciation can be calculated from your cash flow statement, where it’s added as a non-cash add-back. Since PP&E values decrease over time due to depreciation, adding back the depreciation expense for the period adjusts for the reduction in asset value, giving a more accurate figure for actual capital expenditures.

To summarize, the purpose of the CapEx formula is to calculate the amount spent on new or replacement plant, property, and equipment (fixed assets), adjusting for the depreciation that has been recorded in the period. This gives stakeholders insight into how much the company is investing in its long-term assets.

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How to forecast CapEx

There are multiple methods to forecast CapEx, including historical CapEx ratio, maintenance CapEx, and incremental CapEx.

Historical CapEx ratio

The easiest way to forecast CapEx is to use your historical CapEx ratio, which is calculated as percentage of CapEx to revenue or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This approach assumes that the company’s capital expenditure needs will grow at a similar rate to its revenue or EBITDA over the forecasted period. The formula for this approach is:

Forecasted CapEx = Average CapEx ratio (for 3-5 years) x projected revenue

Historical CapEx ratios are grounded in the assumption that the relationship between the company’s scale of operations, as indicated by its revenue or EBITDA, and its capital expenditure needs will remain stable. This approach is particularly useful for businesses in mature industries where past investment patterns are likely a reliable indicator of future needs.

Maintenance CapEx

You can also forecast CapEx using the depreciation plus maintenance CapEx formula. This approach to forecasting CapEx assumes your company will continue to invest in the maintenance of your physical assets, which can be beneficial during times of economic downturn or slow sales.

Forecasted CapEx = Estimated maintenance CapEx for forecast period

By focusing on the costs needed to sustain operations, this method offers a practical view of the minimum investment required to keep existing assets in serviceable condition.

Incremental CapEx

The incremental approach to CapEx starts with the previous period's CapEx as a baseline and adjusts for expected increases or decreases in spending for the upcoming period. Adjustments are typically based on the company's strategic plans, anticipated projects, inflation rates, or changes in operational demands. The formula for this method is:

Forecasted CapEx = Last period CapEx + incremental adjustment

This method suits companies in stable environments where future investments are expected to follow historical patterns. It offers a straightforward way to align CapEx planning with strategic objectives, using existing data while accommodating future needs.

Common challenges managing CapEx

  1. CapEx can be difficult to measure
    The impact of CapEx can be difficult to measure after the initial purchase of a new asset. The challenge lies in aligning investments with the company’s strategic objectives, and ensuring the investment will deliver the anticipated returns, as well as contribute to the company's growth, efficiency, or competitive advantage.

  2. CapEx can be unpredictable
    Before investing in a new plant, property, or equipment it can be challenging to predict the value it will offer your business in the long term. It can be difficult to predict the amount of ongoing maintenance plants or equipment need, or how the real estate market may affect property values. This is why due diligence and scenario planning are important before making new investments.

  3. CapEx is irreversible
    Capital expenditures are forward-looking investments, locking in company resources with the expectation of long-term value. However, this commitment means CapEx decisions are challenging to reverse without financial implications. Selling an asset, especially before its expected lifespan ends, often leads to a significant loss due to depreciation and market shifts. This underscores the importance of thorough analysis and strategic foresight in CapEx planning.

CapEx FAQs

Still have questions about CapEx? Let’s cover some of the most frequently asked questions below!

What does CapEx tell you about a company?

The amount of capital expenditure a company makes tells you they’re invested in their growth and making investments into acquiring, maintaining, or upgrading assets to support their long-term success. This investment into physical assets is generally viewed as a sign that the company is poised for growth and is working towards sustaining and increasing its market share and productivity over time.

How is CapEx treated on a balance sheet?

CapEx is treated as an asset on a company’s balance sheet.

Conclusion: Make CapEx planning a breeze with Prophix One

In summary, we've covered the essentials of CapEx, from its definition and real-world examples to calculation methods and common management challenges.

With Prophix One, a Financial Performance Platform, you can integrate detailed capital asset costs into historical financial statements and investigate how capital expenditure impacts your company’s performance.

Ready to tackle CapEx planning at your organization? See what you can do with Prophix One Financial Planning & Analysis.

Armed with this knowledge, you're now better equipped to make informed CapEx decisions for your organization's growth.

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